The Tax Advantages of Qualified Dividends

Steady income becomes increasingly important as you approach retirement. While most investors are familiar with dividends, you might not fully understand the difference between “qualified” and “non-qualified” dividends. And unfortunately, mistaking the two can have a significant impact on your after-tax investment income.

In this article, we’ll explore the tax advantages of qualified dividends and help you maximize your after-tax investment income.

What Are Dividends?

Dividends are payments made by a corporation to its shareholders. They’re a way for companies to distribute a portion of their earnings back to investors, providing a source of passive income as a reward to long-term shareholders. Some companies have been paying dividends for hundreds of years, including York Water Company’s 200+ year dividend!

Before 2003, all dividends were taxed as ordinary income, subject to your marginal income tax rate, which could be as high as 37%. This higher tax rate on dividends was seen by some as a form of double taxation, since corporate profits were taxed at the corporate level and then taxed again when distributed as dividends to shareholders.

As a result, many companies began to prefer stock buybacks over dividends to reward shareholders. Rather than a taxable cash dividend, buybacks reduce the number of outstanding shares without any tax implications. And with fewer outstanding shares, each share should increase in value to maintain the same market capitalization. 

Qualified vs. Non-Qualified Dividends

President George W. Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) into law, introducing the concept of “qualified” dividends. These were made permanent in the American Taxpayer Relief Act of 2012. The goal was to eliminate double taxation and encourage long-term investment in corporations among retirees.

Qualified Dividends

Qualified dividends meet specific criteria set by the IRS, allowing them to be taxed at the lower capital gains tax rates rather than ordinary income tax rates. 

To be considered “qualified,” dividends must:

  1. The dividend must be paid by a U.S. corporation or qualified foreign corporation, which includes most publicly traded companies on U.S. exchanges.
  2. You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

The second requirement is usually what leads some people to pay higher taxes on dividends. If you don’t hold the dividend-paying stock long enough, you’ll be taxed at the higher ordinary income tax rate regardless of whether the dividend is qualified or not. Keep in mind that any long-term investor who buys and holds a stock will meet the requirements for a Qualified Dividend when available.

Non-Qualified Dividends

Non-qualified dividends, also known as “ordinary” dividends, do not meet the IRS criteria for qualified dividends. These are taxed at your regular federal income tax rates, which can be significantly higher than the rates for qualified dividends.

Impact on Retirement Savings & Income

The primary benefit of qualified dividends is, of course, their preferential tax treatment. While non-qualified dividends are subject to ordinary income tax (also known as the short-term capital gains tax), qualified dividends incur the lower long-term capital gains tax rate. This difference can result in significant tax savings, especially for investors in higher tax brackets.

Let’s break down the differences depending on the 2024 income of a unmarried individual:

Tax BracketOrdinary Income RateCapital Gains Rate
$0 to $11,60010%0%
$11,600 to $47,15012%0%
$47,150 to $100,52522%15% over $47,025
$100,525 to $191,95024%15%
$191,950 to $243,72532%15%
$243,725 to $609,35035%20% over $518,900
$609,350 or more37%20%

Note: This table compares ordinary income (short-term capital gains) with (long-term) capital gains for an individual, unmarried taxpayer. Source: Tax Foundation

To illustrate the potential tax savings, let’s consider an example:

Suppose you’re a single, unmarried filer with a taxable income of $120,000, putting you in the 24% marginal tax bracket for ordinary income. You receive $10,000 in dividend income.

  • If these dividends are non-qualified: Tax owed = $10,000 x 24% = $2,400
  • If these dividends are qualified: Tax owed = $10,000 x 15% – $1,500

In this scenario, having qualified dividends instead of non-qualified dividends would save you $900 in taxes. Moreover, if you invested that extra $900 each year and earn a 7% average annual return, that could become $12,624 after ten years, $37,421 after 20 years, or a whopping $84,793 after 30 years—a lot to miss out on due to taxes!

These tax advantages become even greater for investors in higher tax brackets. For those in the top 37% income tax bracket, the difference between paying ordinary income rates and the 20% qualified dividend rate can result in tax savings of 17%. And after compounding that over time, it can add up to a lot of opportunity cost for your portfolio!

Strategies to Maximize Qualified Dividends

Knowing the difference between qualified and non-qualified dividends is just the first step. To truly benefit from this preferential tax treatment, you must implement strategies to maximize your qualified dividend income and mitigate your non-qualified dividend taxes.

The first step is finding qualified dividend-paying stocks. The good news is most U.S. stocks and foreign stocks trading on U.S. exchanges qualify. But the highest quality companies are the so-called Dividend Aristocrats—S&P 500 companies that have increased their dividend payouts for at least 25 consecutive years. These are a safe bet for many retirement portfolios.

You can also use dividend screeners like the one on TrackYourDividends to find the right opportunity. Rather than choosing for just a handful of Dividend Aristocrats, you can fine-tune options based on your income requirements and risk tolerance. For example, you might look for stocks with a high safety score and low P/E ratio as prime candidates.

Qualified Dividends

TrackYourDividends makes it easy to visualize dividend growth over time based on your actual portfolio holdings and customizable assumptions. Source: TrackYourDividends.com

The platform also lets you assess your diversification across industries and sectors, as well as project your dividend income over time. That way, it’s easy to see whether you’re on track to meet your investment income goals at a glance.

The next step is utilizing tax-advantaged accounts to minimize taxes. If you hold non-qualified dividend paying stocks, consider holding them in a tax-advantaged account like a Roth IRA. These accounts let you pay taxes on contributions in exchange for tax-free growth—including any income generated from non-qualified dividends.

And finally, it’s always a good idea to diversify. While focusing on qualified dividends is important for tax efficiency, don’t let it be the sole driver of your investment decisions. Diversify your portfolio across different sectors and companies to manage risk and potentially capture more growth opportunities. And don’t forget to diversify across asset classes, too.

The Bottom Line

Understanding and maximizing qualified dividends can be a powerful strategy for boosting your after-tax returns, especially as you approach retirement. However, it’s crucial to remember that tax efficiency shouldn’t be the sole driver of your investment decisions. A well-rounded strategy should also consider financial goals, risk tolerance, and more.

If dividends are central to your investment strategy, consider tools like TrackYourDividends to help find the best opportunities matching your requirements and project your income over time. After connecting your accounts, you can access a real-time picture of your dividend income and ensure that you’re on track for retirement. Get started for free!

Remember, every dollar saved in taxes is another dollar working for your future. Make qualified dividends a key part of your investment strategy, and you’ll be on your way to maximizing your after-tax investment income for years to come.