Ever look at your year-end investment tax forms and wonder what “Qualified Dividend” means? In a nutshell, it means you are taxed at the favorable capital gains rates.
Capital Gains Rates - Qualified dividends are taxed at the same favorable 0%, 15%, or 20% rates that apply to long-term capital gains. Dividends that aren't qualified are taxed as ordinary income, at rates as high as 39.6%.
Additional Net Investment Income Tax - If you are a “high earning” taxpayer(1), the qualified dividends are subject to a 3.8% tax on net investment income tax. After the 3.8% tax is factored in, the top rate on capital gains and qualified dividends is 23.8%.
What are Qualified Dividends? - Qualified dividends are received from domestic corporations or from qualified foreign corporations, which include U.S. possessions corporations, foreign corporations whose stock is traded on established U.S. securities markets, and foreign corporations eligible for income tax treaty benefits.
Holding Periods – Be aware that there are 61 day and 91 day holding period rules for common and preferred stocks, respectively. We won’t discuss the details here.
Dividends That Are Not Treated as Qualified - Qualified dividend income does not include the following:
(1) dividends on any share of stock to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property, for example, in connection with a short sale;
(2) any payment in lieu of dividends, for example, payments received by a person who lends stock in connection with a short sale;
(3) dividends that you elect to treat as investment income for purposes of the rules governing the deduction of investment interest;
(4) dividends from a tax-exempt charitable, religious, scientific, etc., organization, religious or apostolic organization, qualified employee trust, or farmers' cooperative;
(5) deductible dividends paid by mutual savings banks, etc.;
(6) deductible "applicable dividends" paid on "applicable employer securities" held by an employee stock ownership plan (ESOP);
(7) dividends received as a nominee.
Mutual Fund Dividends - If you own shares of a mutual fund that holds dividend-paying stock then, to the extent that the dividends received by the mutual fund are qualified dividend income the dividends are taxable at the 0%, 15%, or 20% maximum rates. The mutual fund reports your dividend income on Form 1099-DIV including the qualified dividend income.
Other Pass Through Entities - Dividends received partnerships, S corporations, estates, trusts, and real estate investment trusts (REITs) you own are tracked and reported to you by that entity. By and large, the qualified dividend income of these entities is taxed as qualified dividend income by the partner, shareholder or beneficiary.
Effect of capital losses on dividends - While qualified dividend income is taxed at the same rates as long-term capital gain, it isn't actually long-term capital gain. Therefore, you can't use capital losses that otherwise enter into the computation of your taxable "net capital gain" (the excess of net long-term capital gain over net short-term capital loss) to offset your qualified dividend income. As a result, generally, your qualified dividend income will be taxed in full at the 0%, 15%, or 20% rates.
However, if your capital losses exceed your capital gains for the tax year, the excess, up to $3,000, can be used to offset other income. This offset can be used against qualified dividend income, but only after it's been used against taxable income other than qualified dividend income. However, this "ordering" rule is actually a benefit, because offsetting taxable income other than qualified dividend income, which is taxable at rates up to 39.6%, saves more tax than offsetting qualified dividend income, which is taxed at no more than 20%.
Planning - The taxation of dividends at the favorable 0%, 15%, and 20% rates may make investments in dividend-paying stock significantly more advantageous than investments that produce income taxed at rates as high as 39.6% (for example, rental real estate, or any type of investment that produces taxable interest).
Please consult a qualified tax advisor if you have any questions on whether any of your dividend income is qualified dividend income.
(1) Taxpayers with modified adjusted gross income (MAGI) that exceeds $250,000 for joint returns and surviving spouses or $200,000 for single taxpayers and heads of household.