When it comes to investing in stocks or other securities that pay out dividends, there are two types of dividends you may receive: ordinary dividends and qualified dividends. Qualified dividends receive favorable tax treatment and are taxed at a lower capital gains rate than ordinary dividends. What makes a dividend qualified depends on how long you hold onto the security, along with other criteria established by the IRS.

Here’s an overview of dividends, how each type of dividend works and what that means for your taxes.

What are dividends?

Let’s start with the basics: a dividend is a portion of a company’s earnings that’s distributed to shareholders. These earnings are usually paid out on a regular basis, such as quarterly, monthly or annually, and can be in the form of cash or additional shares of stock.

Ordinary Dividends

Ordinary dividends are called ordinary because they are taxed as ordinary income, which means your regular income tax rate. For some, this can mean as high as 37 percent for federal income tax if you’re in the highest tax bracket.

Qualified Dividends

Qualified dividends are taxed at a lower rate, generally the long-term capital gains tax rate. The long-term capital gains rate ranges from 0 percent up to 20 depending on your taxable income.

Here’s a quick breakdown of the long-term capital gains tax rates for 2023:

Taxable income

If your taxable income is below $41,675 for single filers or $83,350 married filing jointly, some or all of your net capital gain tax may be taxed at 0 percent. If your taxable income is $41,676 up to $459,750 for single filers or up to $517,200 for married filers, your tax rate 15 percent. If your taxable income exceeds $459,750 for single filers or $517,200 for married filers, a 20 percent rate applies to the excess.

In order for a dividend to qualify for a lower tax rate, it must meet certain criteria set by the IRS. The most important is the dividend must have been paid by a U.S. corporation or a qualifying foreign corporation, and the investor must have held the stock for a minimum amount of time, typically 61 days for common stock and 91 days for preferred stock.

Qualified dividends criteria

Here’s an overview of what makes a dividend qualified:

  • The dividends were received from domestic or qualified foreign corporations.
  • The stock or mutual fund share was held for the required holding period.
  • The investment is not a real estate investment (REIT), master limited partnership (MLP), employee stock option, tax-exempt company or listed with the IRS as an investment that doesn’t qualify.
  • The asset was not hedged, which means calls and puts or other derivatives weren’t used.

For more details and the latest guidance, check the IRS website and publications or a tax professional as these criteria may change.

How will I know if my dividends are qualified or ordinary?

You can find out whether your dividends are qualified or ordinary on the IRS Form 1099-DIV that your broker or trading platform sends you each year. It will have ordinary dividends listed in box 1a and qualified dividends in box 1b.

However, if you’re hoping to find that information per dividend stock, you’ll have to chat with your broker, or read through the IRS list for what makes a dividend qualified to see if the investment meets the requirements. For investors with portfolios that include foreign companies or alternative investments, it will be a little trickier than an investor who focuses on U.S. common stocks. Most major U.S. common stocks will likely count as qualified, as long as you meet the holding period requirement.

Why are qualified dividends taxed differently?

The idea behind this tax policy is to encourage long-term investment in the stock market. By offering a lower tax rate on qualified dividends, the government hopes to incentivize investors to hold onto their investments for a longer period of time, which can be beneficial both for the individual investor and for the overall economy.

Bottom line

Let’s recap: the primary difference between ordinary dividends and qualified dividends is how they are taxed. Ordinary dividends are taxed as ordinary income at your regular tax rate, while qualified dividends are taxed at a lower rate, similar to the long-term capital gains tax rate. To qualify for the lower tax rate on qualified dividends, the dividends must meet certain criteria set by the IRS. If you’re still unsure if your dividend yielding investments are qualified or ordinary, consult a financial professional for further clarification and advice.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.