As an investor, understanding what qualified dividends are and how they’re different from ordinary dividends can help you avoid excessive tax penalties.

This may not be one of the most exciting topics to most of us. However, understanding what qualified dividends are is of great importance. In addition to playing a central role in increasing ROI of your investment, it can potentially save you thousands of dollars on your tax bill.

So what exactly are Qualified Dividends?

From the IRS perspective, qualified dividends are essentially ordinary dividends that meet specific criteria when it comes to how they’re taxed. These criteria allow qualified dividends to be taxed at a lower capital gains tax and not at a higher tax rate for ordinary dividends. Unlike ordinary dividends that are normally taxed at a rate ranging between 10% and 37%, qualified dividends are taxed as capital gains tax at a rate ranging from 0%, 15%, and 20%.

Qualified dividends are of great importance as they allow you to pay much lower taxes than ordinary dividends. In other words, they’re subject to special lower taxes.

Requirements for Qualified Dividends

There are special requirements that a dividend must meet to be categorized as qualified dividends. The dividend must be paid by one of the following:

The dividend must also meet a specified holding period. For instance, you must have held the stock for more than sixty days during the 121-period that starts sixty days before the first date following the declaration of the dividend, which is commonly known as the ex-dividend rate. Simply put, the holding period should be at least 60 days for common stock, 60 days for dividend-paying mutual funds, and 90 days for preferred stock.

How Do Qualified Dividends Work?

Here’s a perfect example. Let’s assume that Smith owns 20,000 shares in ABC stock. The stock pays Smith $0.50 per year in dividends. As a result, Smith receives 20,000 x $0.50 = $10,000 annual dividends from ABC. Given that ABC is a U.S. corporation; its stocks are eligible for qualified dividends. Smith is, therefore, eligible to pay capital gains tax of say 15% on the dividends and NOT ordinary income tax of say 37% on the dividends.

What is the Importance of Qualified Dividends (Why Does it Matter)?

For many investors in the U.S., the issue of qualified dividends doesn’t matter that much. This is basically because most dividends from U.S. corporations are categorized as qualified dividends and are eligible for capital gains tax, which is significantly much lower than ordinary taxable income for ordinary dividends. On the other hand, it’s crucial to check out whether your dividends are eligible as qualified dividends if you normally invest in foreign companies, Real Estate Investment Trusts (REITs), or Master Limited Partnerships (MLPs).

All in all, qualified dividends can enable you to maximize ROI on your investments given that they’re eligible for lower capital gains tax. As an investor, you can’t do much to ensure that your dividends are qualified dividends. However, you can consider holding the stocks for the minimum holding period and you might be eligible for qualified dividends.

As always - this post is not to be taken as financial advice. Please consult a financial advisor before making any financial decisions.