Investing 101: Qualfied Dividends

Qualified dividends are dividends that are subject to lower tax rates than ordinary dividends because they fit certain specific criteria under the US Internal Revenue Code (or as it's more popularly known, the tax code). Normally, dividends are taxed as ordinary income. Qualified dividends, though, are subject to capital gains tax, which decreases the investor's tax burden. However, this may change in 2011. Unless Congress extends the existing tax cuts, all dividends will be taxed as ordinary dividends at 2001 tax rates, effectively rendering the concept obsolete.

Understanding Qualified Dividends

Dividends are payments made by companies to their stockholders. Those payments represent portions of the company's profits. As such, they are considered income for tax purposes.

As mentioned above, qualified dividends are taxed as capital gains. The capital gains are taxed less then ordinary income. That is because the US government wants to encourage investment in certain types of stocks in hopes that such investments will help the economy.

In order to be considered qualified dividends, dividends must meet the following requirements:

  • Time frame requirement--The dividend must be paid between January 1, 2003, and December 31, 2010.
  • Qualified company requirement--The company that pays the dividend must be a US corporation or a corporation that was incorporated in a US territory (such as Puerto Rico, American Samoa, etc). If the dividend is paid by a foreign corporation, said corporation must be located in a country that either has a tax treaty with the United States that specifically allows the US government to tax its dividends as qualified dividends or has a stock that's traded in an established US stock market.
  • Holding period requirement--The stock that generates the dividend must be held for at least 61 days during the 120-day period. Said period must begin 60 days before the reinvestment date and end 59 days after the reinvestment date.

Luckily for the investors, they don't have to figure out whether their dividends fit the requirement. The stock-owning company will do it for them. It will be listed on a copy of the IRS tax form 1099-DIV that they will receive from the company before they have to file their tax returns.

Qualified Dividend Tax Rates

The tax rates for qualified dividends are determined based on the investor's income bracket and the year in which the dividend was paid. For dividends issued between January 1, 2008, and December 31, 1010, investors in 10 and 15 percent income brackets aren't taxed at all. Investors in higher tax brackets are taxed at 15 percent.

If the tax cuts aren't extended, the qualified dividends will be taxed at the same rates as ordinary dividends. Under this setup, the 10 percent income bracket will disappear, and investors in other income brackets will be taxed at the same percentage as their bracket. For example, the investor in a 15 percent income bracket will be taxed at 15 percent, an investor in a 28 percent income bracket will be taxed at 28 percent, etc.

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