Not all dividends are created equal, and investors need to be aware of this fact. The seemingly minor differences can make a big impact on bottom line returns.

There are two different types of regular dividends, qualified and unqualified. Knowing the difference between the two is a big deal for investors around tax time as the tax implications can affect the maximum return on investment.

The Big Difference

A qualified dividend is a type of dividend that is taxed at the capital gains tax rate. Generally speaking, most regular dividends from U.S. companies with normal company structures (corporations) are qualified. For individuals, estates, and trusts, qualified dividends are taxed at the current capital gains rate of 15%. For individuals whose income tax rate is 10% or 15%, then the capital gains tax rate is zero. As of January 2, 2013 the dividend and capital gains tax rate will now be 20% for investors making over $400,000 and households making over $450,000.

These qualified rates are lower than the typical income tax rate that unqualified, or ordinary, dividends are applied to. Non-qualified dividends do not qualify for the lower tax preference and are thus taxed at an individual’s normal income tax rate. Regardless of your tax bracket, this difference means you will pay significantly higher taxes on a non-qualified payout. For more dividend education, check out  The Truth About The Dividend Payout Ratio.

Eligibility Requirements for Investors

The IRS states that “qualified dividends are dividends paid during the tax year from domestic corporations and qualified foreign corporations.” For the most part, this means that regular (usually quarterly) dividends paid out to shareholders of for-profit companies on the New York Stock Exchange, NASDAQ, AMEX, or other domestic corporations that might not trade on the stock exchanges, are usually qualified and thus taxed at the reduced capital gains rate.

However, investors must meet certain requirements to enjoy the reduced tax rate. Investors must adhere to a minimum holding period. For common stock, a share must be held more than 60 days during the 120-day period beginning 60 days before the ex-dividend date. For preferred stock, the holding period is 90 days during the 180-day period beginning 90 days before the stock’s ex-dividend date. So if an investor is paid a dividend by Apple (AAPL) or Microsoft (MSFT) and they meet the holding period criteria then those dividends are qualified. If the holding period is not met then the dividend is unqualified (and thus taxed at the normal income tax rate).

What’s Qualified and What Isn’t

Some examples of dividends that are unqualified, and thus do not qualify for the tax preference, are those paid out by real estate investment trusts (REITs) and master limited partnerships (MLPs), dividends paid on employee stock options, dividends paid by tax-exempt companies, and dividends paid on savings or money market accounts. Dividends received in Individual Retirement Accounts (IRAs) are also unqualified, although this distinction is essentially meaningless since most capital gains and dividends in IRAs are not taxed to begin with. Finally, special (one-time) dividends are also non-qualified.

A foreign corporation’s dividends are qualified if the company itself is considered qualified. The IRS states that a foreign corporation is qualified “if it is incorporated in a possession of the United States or eligible for benefits of a comprehensive income tax treaty with the United States that the Treasury Department determines is satisfactory for this purpose and that includes an exchange of information program.” This means that the foreign firm must be tied to the United States in some way and/or be in a country that has a tax agreement in place with the IRS and Treasury Department. There are many things that dividend investors need to be aware of; find out what they are in 5 Common Misconceptions About Dividend Investing.

The Bottom Line

For the most part, investors need not worry about the differences between qualified and unqualified dividend as most regular dividends from corporations are indeed qualified. However, when it comes to investing, an individual should always be aware of the tax implications that might affect potential returns. Here at Dividend.com we try to assist investors by indicating whether a company’s dividend is qualified or not on the individual company’s company profile. To have a clear understanding of qualified and unqualified dividends and how it will affect overall bottom line returns, an investor should stay in communication with their broker and accountant.

http://www.dividend.com/dividend-education/qualified-vs-unqualified-dividends/