Dividends are taxed in different ways, depending on their classification as either qualified or ordinary dividends. In essence, qualified dividends are taxed at a lower rate than ordinary dividends. The tax rate for ordinary dividends is the ordinary tax rate, which can be twice as high as the tax rate for qualified dividends (depending on the applicable tax bracket). The tax on qualified dividends has ranged in recent years from 0% to 15%, depending on the recipient's tax bracket. A 20% tax applies to those with high incomes.
How to tell if dividends are classified as qualified? The basic criteria for classifying a dividend as qualified are:
- Holding period. The dividend recipient must have had ownership of the stock for a period of greater than 60 days during the 121-day period that begins 60 days prior to the ex-dividend date. The ex-dividend date is defined as the first date immediately following the declaration of a dividend by a company's board of directors, when the purchaser of an entity's stock is not entitled to receive the next dividend payment.
- Payer. The entity paying the dividend must be either a United States corporation, or a foreign corporation whose country qualifies under a tax treaty with the United States, or a foreign corporation whose stock is readily traded on an established stock exchange within the United States.
A dividend that qualifies under these criteria is stated as such on the Form 1099-DIV, which is issued to shareholders following the end of each calendar year.
The significant tax difference between these two types of dividends should drive investors to hold their dividend-paying stock for longer periods of time.