Tax Advantages Add Appeal to Qualified Dividends
By: Jonathan Wolfgram,
qualified dividends benefit from lower capital gains tax rates to boost the income that shareholders can keep from their payouts compared to ordinary dividends. This is referred to as the qualified dividend tax advantage — the tax advantage held by qualified dividends adds to their appeal as a reliable source of income for investors. When deciding between specific dividend-paying stocks, choosing an equity that pays qualified dividends could add to total returns of an investment, compared to ordinary dividends that are taxed at higher rates.
In certain cases, investors in the top tax bracket could save almost 46% of their federal tax bill on the dividend distributions collected for the year. Although exceptions exist, shareholders usually can find out if the payouts they receive come from qualified dividends by looking for box 1b on the tax Form 1099-DIV that are sent from entity distributing the payouts.
Prior to 2018 the capital gains tax rates – 0%, 15% and 20% – aligned well with seven tax brackets for ordinary income. Investors who paid ordinary income in the 10% or 15% ordinary income bracket had no tax liability on their qualified dividends. If the investor’s ordinary income fell into one of the higher tax brackets – 25%, 28%, 33% or 35% – excluding the top bracket, a 15% tax rate applied for the qualified dividend distributions. Lastly, investors in the 39.6% top bracket for ordinary income paid a 20% tax on their qualified dividends.
While the three brackets and rates for capital gains remained unchanged after Congress passed the Tax Cuts and Jobs Act (TCJA) on December 22, 2017, the brackets no longer align with the reduced cutoffs for ordinary income tax brackets. For 2018, investors filing taxes as singles will pay no capital gain taxes on income up to $38,600, or up to $77,200 if married and filing jointly. The 15% tax bracket applies on all income between $38,600 and $425,800 for single tax payers and between $77,200 and $479,000 for married taxpayers filing jointly. The 20% top bracket tax rate applies to all income above $425,800 for single tax payers and above $479,000 for married investors filing a joint tax return.
Although qualified dividends are coveted, investors typically will focus on parameters such as a stock’s share price history, its moving averages, technical indicators, history of dividend payments, consecutive periods of dividend boosts and financial results to select investments.
To qualify for the lower tax rates and receive the qualified dividend tax advantage, qualified dividends must meet all three of the following criteria,
1. The dividends must be distributed by a U.S. corporation or a qualified foreign corporation. The Internal Revenue Service (IRS) defines a Qualified Foreign Corporation as any company that meets all three of the following conditions:
a. The corporation is incorporated in a U.S. possession.
b. The corporation is eligible for the benefits of a comprehensive income tax treaty with the United States that the Department of the Treasury determines is satisfactory for this purpose and that includes an exchange of information program. The IRS website contains the full list of eligible treaties in Table 3. List of Income Tax Treaties.
c. The corporation does not meet (a) or (b) above, but the stock for which the dividend is paid is a readily tradable stock on one of the established National Security Exchanges in the United States. These securities markets must be registered under Section 6 of the Securities Exchange Act of 1934 or on the Nasdaq Stock Market.
2. The dividends are not of the type listed by the IRS as “Dividends that are not qualified dividends.” The dividends listed below are not qualified dividends even if they are listed in box 1b of Form 1099-DIV,
a. Capital gain distributions.
b. Dividends paid on deposits with mutual savings banks, cooperative banks, credit unions, U.S. building and loan associations, U.S. savings and loan associations, federal savings and loan associations and similar financial institutions. Dividends from these institutions are interest income.
c. Dividends from a corporation that is a tax-exempt organization or farmer’s cooperative during the corporation’s tax year in which the dividends were paid or during the corporation’s previous tax year.
d. Dividends paid by a corporation on employer securities held on the date of record by an employee stock ownership plan (ESOP) maintained by that corporation.
e. Dividends on which the investor must make related payments for positions in substantially similar or related property.
f. Payments in lieu of dividends, but only if the shareholder knows or has a reason to know the payments are not qualified dividends.
g. Payments shown on Form 1099-DIV, box 1b, from a foreign corporation, which the shareholder knows or has a reason to know that the payments are not qualified dividends.
3. The investor owns the shares for a specific amount of time to satisfy the holding period requirement. Specifically, to meet the holding period condition for qualifying dividends, investors must own common shares for more than 60 days during a 121-day period, which starts 60 days prior to a declared ex-dividend date. The same requirement applies for dividends paid on preferred shares that are due for periods of less than 367 days. However, dividends on preferred shares that are due for periods totaling more than 366 days have a slightly longer holding period requirement. To achieve eligibility for qualified dividend status for this second category of preferred shares, investors must own the shares for more than 90 days during a 181-day period that starts 90 days ahead of the ex-dividend date. When shares change ownership, the transaction date counts towards the seller’s holding period. The buyer’s holding period begins the day after the transaction.
1. Unless informed otherwise by the equity that made the distributions, it is safe to assume that the dividends received on common and preferred stock are ordinary dividends. For tax filing purposes, most entities distributing dividends will provide a Form 1099-DIV, which will list the total amount of ordinary dividends paid in box 1a.
2. Additionally, certain types of dividends are ineligible for qualified status consideration, even if they meet all the qualifying eligibility requirements listed in the previous section. Dividend distributions from tax-exempt companies, master limited partnerships (MLPs) and real estate investment trusts (REITs) are always treated as ordinary dividends. Additionally, dividends on employee stock options and special, one-time dividends are also ineligible for qualified dividends classification.
3. Dividend distributions from money market accounts, such as deposits in savings banks, credit unions or other financial institutions are technically distributions of interest and must be reported as interest income for tax purposes. Furthermore, any dividend distributions associated with hedging – call options, put options, short sales, etc. – are equally ineligible for the qualified status. All these types of dividends cannot be qualified dividends and are taxed as ordinary income.
Dividends in general are periodic distributions of a company’s assets to its shareholders. These distributions can sometimes take different forms, such as stock distributions. However, the Internal Revenue Service (IRS) considers stock dividends as stock splits. Therefore, stock dividends carry no immediate tax liability. Stock dividends are treated as unrealized gains and capital gains taxes assessed upon the sale of the shares.
Cash dividends, whether derived from company’s earnings, interest or any other source, carry tax liability for the year in which the dividend is distributed and the IRS assesses the standard ordinary income tax rates for all ordinary dividends. However, there is an exception to this rule.
A regulated investment company (RIC), such as a mutual fund, an exchange-traded fund (ETF) or a unit investment trust (UIT), might declare a dividend with a Date of Record in October, November or December but distribute the dividend payments in January of the following calendar year. In that case, the dividend paid in January will be deemed as to have been paid on Dec. 31 the prior year and must be included in that year’s taxable income.
For investors, the tax-advantage of qualified dividends make them preferable to ordinary dividends.
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