Understanding what qualified dividends are and how they differ from ordinary dividends is crucial to your investment success. They can play a central role in increasing your Return on Investment (ROI). They may also potentially save you thousands of dollars on your tax bill.
From the IRS perspective, qualified dividends are ordinary dividends that meet specific criteria regarding how they are taxed, whcih allows them to be taxed at a lower capital gains tax. Normally, ordinary dividends are taxed at a rate ranging between 10% and 37%. But qualified dividends are taxed as capital gains tax . This means they are taxed from 0%, 15%, and 20%. In other words, they’re subject to special lower taxes.
There are special requirements that a dividend must meet to be categorized as a qualified dividend. The dividend must be paid by one of the following:
- A corporation incorporated as a U.S. possession
- A U.S. corporation, including mutual funds
- A foreign corporation that is entitled to benefits under a U.S. tax treaty
- A foreign corporation stock that can be freely transacted on a reputable U.S. stock market, for example, an American Depository Receipt
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-day period that starts 60 days before the first date following the declaration of the dividend. This date 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 Qualified Dividends Work
Here’s an example of how they work. Let’s assume that Smith owns 20,000 shares in XYZ 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 XYZ. Given that XYZ 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.
Why It Matters
For many investors in the U.S., the issue of qualified dividends doesn’t matter that much as most dividends from U.S. corporations are categorized as qualified dividends and are eligible for capital gains tax. On the other hand, it’s crucial to check out whether your dividends are eligible as qualified status if you normally invest in foreign companies, Real Estate Investment Trusts (REITs), or Master Limited Partnerships (MLPs).
The bottom line is that qualified dividends can enable you to maximize ROI because they are eligible for lower capital gains tax, making them an optimal choice foe many investors.
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