What type of account are you using?
When it comes to taxes, the type of account you are using will make a big difference.
An ordinary dividend will be taxed as ordinary income at your marginal tax rate. This could be as high as 37%. But if an ordinary dividend meets certain requirements, it will become a qualified dividend. A qualified dividend “qualifies” for the lower long-term capital gains tax rate, which maxes out at 20% and is only 15% for most people.
How does an ordinary dividend become a qualified dividend?
To become a qualified dividend, three general requirements must be met.
First, the dividend must be paid by either a U.S. corporation or qualified foreign account. Secondly, the dividend cannot be paid by a non-qualifying entity, including but not limited to REITs, MLPs, and ESOPs.
Lastly, to become a qualified dividend, you must have owned the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date. For example, day 1 would be 60 days before the ex-dividend date. Then, the ex-Dividend Date would count as day 60. 60 days after the ex-dividend date counts as day 121. Learn more about dividend dates.
What about long-term investors?
The rules may sound confusing, but if you are a long-term buy and hold investor, your dividends should automatically meet the qualified dividend criteria.
Because qualified dividends are taxed at the lower capital gains rate, they are more tax-efficient and will allow you to keep significantly more of your income than a similar ordinary dividend.
This difference between ordinary dividend income and qualified dividend may be more important to high-income earners who fall into the highest tax brackets.