Qualified dividends are like the loyalty rewards program of the stock market. Basically, they’re an incentive for shareholders, the people who own stock in a company, to keep their money parked there for the long term.
And while you shouldn’t buy anything solely for the dividends (there are other things, like a long track record of strong returns, to consider when picking a fund), they’re there to reward those who don’t buy and sell short-term.
Let’s take a closer look at how qualified dividends work and whether they belong in your portfolio.
What Is a Qualified Dividend?
Remember, dividends are regular payments of a company’s profits to shareholders (usually in cash). Qualified dividends are a special type of dividend payout. If your shares meet a certain set of requirements, then you’ll be taxed at a lower rate. Depending on your investing strategy and income, this can make a big difference in your tax bill.
Unqualified dividends, also called ordinary or nonqualified dividends, are taxed at your regular federal income tax rate. These dividends are unqualified because they haven’t met the same set of requirements as qualified dividends. We’ll get to the requirements here in just a minute.
Qualified Dividends: Terms You Need to Know
The world of qualified dividends is full of investing jargon and confusing terms. Here’s a little “cheat sheet” to help you understand what these terms and phrases mean:
- Record date: When a company announces they’re going to pay out dividends, they also set a date—the record date—for when shareholders must already be on the company’s books as a shareholder in order to receive a dividend.
- Ex-dividend date: Think of this as the cutoff date to buy your shares of stock so that you can receive a dividend. The ex-dividend date (or ex-date) is usually two business days before the record date.
- Holding period: In order for a dividend to be a qualified dividend, you basically have to buy your shares before the ex-dividend date and hold onto them for at least 61 days. But not just any 61 days. Those 61 days have to fall within a 121-day period (or four months) that begins 60 days before the ex-dividend date and ends 60 days after the ex-dividend date. Don’t look at us, we didn’t come up with the rules.
How the Holding Period Works
Now, all this record date, ex-date and holding period stuff can be confusing. Most of the time, you’re not going to need to worry about all these complicated rules. When you work with an investment professional, they’ll help you through this. But for those who want to know details, here’s how the holding period works.
Market chaos, inflation, your future—work with a pro to navigate this stuff.
Company A says it’s going to dish out dividends and they choose a record date of May 1 (you have to officially own their stock before that day—or no qualified dividends for you). Now to make sure you make it on the books, companies always require you to buy their stock two business days before the record date (they call this the ex-dividend date). So in this case, the ex-dividend date is April 29.
You buy their stock April 20. Now as long as you hold their stock for 61 days (until at least June 20), your dividends are qualified. If you sell your shares before then, your dividends are nonqualified. Simple right?
Reason #274 why it’s worth it to work with an investment pro.
Dividend Payable Date
How Are Qualified Dividends Taxed?
Qualified dividends were created to encourage shareholders to invest their money in companies for longer periods of time. In return, shareholders’ dividends are taxed at the long-term capital gains tax rate rather than their federal income tax rate. A long-term capital gain is when you buy something—like a share of stock—keep it for at least one year, and then sell it for more than you originally bought it for.
Having the profits you made on your shares taxed at a long-term capital gains tax rate instead of your federal income tax rate could be a difference of hundreds, thousands, and yes, even millions of dollars. Current long-term capital gains tax rates range from 0% to 20% based on your taxable income, and federal income tax rates range from 10% to 37%. See? A big difference, especially as you move up in income.
Let’s take a look at an example. Say you buy 100 shares of a mutual fund (some mutual funds offer qualified dividends too!). At the end of the quarter, the fund announces a $2 dividend per share. Guess what? You just made $200. If the mutual fund does this all year, you’re up $800.
Now, whether you take the cash dividends or reinvest them, you’re still taxed. Dividends are treated like income. But how you’re taxed can look pretty different. So if you’re a single filer making $40,000 or less per year, you’ll pay zero long-term capital gains tax on your $800. Zero! Or say you’re a single filer who makes more than $441,450 per year, you’ll pay 20% in capital gains tax, or $160, instead of your 35% income tax rate, or $280. That’s $120 that stays in your pocket instead of going to the IRS!
What Are the Requirements of a Qualified Dividend?
In order for a dividend to be a qualified dividend, it has to meet certain conditions:
- Dividends are paid by a U.S. corporation. (Or by a qualified foreign corporation which means they’re incorporated in a U.S. possession, located in a nation with an income tax treaty with the U.S., or their stock is tradable in the U.S. securities market.)
- It’s a regular ol’ dividend. That means no capital gains distributions, dividends from tax-exempt organizations or payments in place of dividends.
- Meet a certain “holding period.” As mentioned above, you bought the stock in time to qualify and held it for more than 60 days.
Definitely make sure to keep an eye on the holding period. Companies do this to prevent investors from buying up a bunch of stock right after a dividend has been announced. Remember, qualified dividends reward long-term shareholders.
Get With a SmartVestor Pro
Don’t unravel all the ins and outs of investing on your own. This is your hard-earned money, so having a dedicated investment professional on your side is a must. When you work with a SmartVestor Pro, you’re getting help from a person that’s committed to your bigger financial picture—that long-term strategy I’m always talking about. They’re here to help you get your financial plan in place, not sell you on products you don’t need or understand.
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.