What Are Qualified Dividends?

If you’ve been investing for a while, you’re probably familiar with the concept of a dividend. That’s the little bonus some companies give you just for investing in them. You may even recall that reinvesting dividends can supercharge your investing returns: Since 1960, a whopping 82 percent of returns for the S&P 500 index have been from growth of reinvested dividends, according to an analysis by Hartford Funds.

But until tax time, you probably weren’t aware that not all dividends are created equal. For Uncle Sam’s purposes, there are two main types of dividends: qualified dividends and ordinary dividends.

What’s a qualified dividend?

A qualified dividend is a dividend that may be eligible for a lower tax rate than other forms of income. Qualified dividends are taxed at a capital gains rate, which may be 20 percent, 15 percent or 0 percent, depending on how much money you make in a year. These rates are generally lower than the amount you pay on other forms of income, like your salary, and are more commonly known as the rate you pay when you sell an investment you’ve held for at least a year.

What’s an ordinary dividend?

An ordinary dividend is any dividend that isn’t qualified and is therefore taxed at the same rate as the rest of your income.

What’s the difference between an ordinary dividend and a qualified dividend?

The amount of taxes you owe is the biggest differentiator. But for a dividend to be a qualified dividend, both you and the dividend must meet a few requirements:

The dividend must be issued by a U.S. company or a qualified foreign corporation. To qualify, foreign corporations must be incorporated in an area considered a U.S. possession, eligible for the benefits of a comprehensive income tax treaty with the U.S. or traded on an established U.S. exchange.

The dividend doesn’t come from certain types of assets. These include real-estate investment trusts (REITs), money market accounts, employee stock options and tax-exempt companies, among others.

You must have held the stock for at least 60 days before the date the dividend is scheduled to be paid. If you have preferred shares of a stock, you may have to have held it at least 90 days before this ex-dividend date.

If your dividend doesn’t qualify as a qualified dividend, that doesn’t mean you don’t benefit from the income and potential for investment growth it provides.

Should I invest in only qualified dividend-paying stocks?

While qualified dividend stocks may offer a slight tax advantage, particularly when large dividend payouts are involved, the average investor probably doesn’t need to worry about the type of dividends their investments pay.

As a passive investor, you probably aren’t investing solely for the dividends, and non-dividend-paying stocks can provide value in countless ways. Certain types of young companies may not pay dividends at all but may offer high growth potential. And some sectors may eschew dividend payments entirely or may be limited to only paying ordinary dividends, like REITs or certain international-based funds.

That’s why a well-diversified portfolio may contain a mix of funds or investments that pay ordinary dividends, qualified dividends or no dividends at all.

How do I know what kind of dividends my investments pay?

Each year, you should receive a 1099-DIV form from the brokerage firm you use. This form will list all of the dividend income you earned by type. You may notice that even within the same index fund, some payments will be ordinary while others will be qualified. This simply points to the diversity of investments the funds themselves contain or indicate that the fund did not hold a particular asset long enough to provide a qualified dividend.

Will I owe taxes on my qualified or ordinary dividends?

You may, depending on if you meet minimum reporting requirements. Check with your tax advisor to see if you may meet these criteria.

Keep in mind that any dividends earned in retirement accounts, like your 401(k) or IRA, may not be taxed until you withdraw from them in retirement. Funds withdrawn from Roth IRA accounts may never be taxed.