Ordinary dividends can be qualified and non-qualified depending on the tax treatment. The qualified dividends are treated with a favorable tax rate (capital gain tax rate), and non-qualified dividends are taxed at the ordinary rate of taxation (income tax rate). The rule of the qualified dividend was introduced in 2003 under the jobs and growth tax relief reconciliation Act.
The treatment of the dividend for tax purposes has a more significant impact on the investor’s overall return. So, the investor needs to understand the type of dividend and the related tax implications.
The qualified dividend receives certain favor in the calculation of the tax liability. So, it results in an improved return on investment and an increase in the investor’s wealth. Generally, dividends are qualified in the following cases.
1- The dividend is paid by the U.S. Company, or the company is located in foreign but gets advantage of the U.S. tax treaty while meeting the other criteria of the qualification.
2- The dividend must not be listed under the list of “not qualified dividends.”
3- The requirements for the holding period are fulfilled by the investor.
Holding period requirement
For common stock, the investor must hold the stock for 60 days in the last 121 days; 121 days start before the ex-dividend date. Let’s understand the rule with the help of the following example.
Date of ex-dividend
The date of ex-dividend is the date when the dividend allocation of the company is specified. In other words, you’ll receive the dividend if you hold the shares on the date of ex-dividend and vice versa. Hence, it acts as a line of demarcation that which share-holders should be paid and should not be paid.
Example of the holding period
Consider the date of ex-dividend for Alpha Plc is March 04, 2021. So, the 60 days before the ex-dividend date would be January 04. Hence, Jan-04 will act as starting date for our count of 60 days eligibility. Now, suppose the investor purchases the common stock on March 01 and sells on April 2. It’s a holding of the shares only for 33 days in the 121 qualified days; as a result, a criterion is not fulfilled.
On the contrary, if stock is purchased on Jan-15 and sold on March-20, the qualified days would be 65 days. Hence, the dividend would be qualified, and a lower tax rate can be applied to it.
For preferred stock, the holding period is 90 days in the 181 days; the qualifying period starts 90 days before the ex-dividend date. The application of the rule is similar to the common stock. However, the qualifying period is greater in preferred stock.
The tax advantage of qualified dividend
The qualified dividend is taxed at the long-term capital gain rate, which is lower than the rates of the ordinary income tax. On the other hand, the non-qualified dividend is taxed at the ordinary income tax rate, which is higher than the rate of long-term capital gain.
There is a substantial difference in tax rates for the long-term capital gain and the ordinary income tax. For instance, if you are a tax-payer in a bracket of 15% or lower, the tax rate for qualified dividends is 0%. If you are taxed in the bracket of 15% – 39.6%, the tax rate will be 15% on the qualified dividends, and if you pay tax on top bracket of more than 39.6%, the rate of tax will be 20% on the qualified dividends.
So, in simple words, the non-qualified dividend is treated as ordinary income and taxed at higher rates. However, the qualified dividend is taxed at relatively lower rates. Further, the advantage of the dividend qualification is also dependent on your level of income and the applicable bracket of the tax.
The non-qualified dividend is when the dividend paid by the company does not meet certain criteria to be qualified, or the dividend is listed in the types that fall under the “not qualified list of the dividends.” In this case, the dividend income of the investor is treated as normal income for taxation.
Following are some of the dividend incomes that come under the list of “dividends not qualified.”
- The dividend paid by the real estate companies or REIT – Real Estate investment trust and the master limited partnership – MLPs.
- The dividend received from the foreign company provided the country of the company does not form part of the United States tax treaty or the securities of the foreign company are not traded in the U.S. stock markets like NYSE and Nasdaq.
- The dividend paid by the companies under the employee’s share options scheme is not qualified.
- Some special dividend/one-time dividend paid by the company is non-qualified.
- Dividends that do not meet the requirement of the holding period as prescribed by IRS are treated as a non-qualified dividend.
A dividend of USD 2 per share received from Alpha Company may have greater value than USD 2 per share received from Gamma plc. It’s because the dividend of the Alpha Company may be qualified for a lower rate of the tax than the dividend of the gamma company.
So, qualified dividends are qualified for the lower tax rate, and non-qualified dividends are charged higher tax – income tax rates. However, there are certain conditions for the dividend to be classified that include dividend should be from U.S. based company or the company operating in a region that has a tax treaty with the United States or they are listed on the established stock exchange of the United States like NYSE or Nasdaq. Further, dividend income must not be part of the list of “dividends not qualified.” In addition to this, the requirement of the holding period has to be fulfilled as required by the IRS.
So, understating which stock to buy and how much time to hold can be essential for appropriate tax planning, which can help get a better return on equity.