If you want to know
“Are dividends qualified?”
Look at holding time

“Qualified” is a word that gets tossed around a lot in finance. There are qualified and non-qualified accounts, qualified and non-qualified withdrawals from accounts, qualified and non-qualified annuities, qualified non-profit organizations, qualified education expenses, etc. Each of these could (and probably will) be it’s own FiKu someday.

Financial professionals and personalities throw these terms around all the time and never actually explain what they mean.

In general, if the term “qualified” is used in the name of a financial account, expense, or entity, it is referring to a tax benefit. Specifically, it is referring to a current-year tax benefit. If something is “qualified,” it is getting some kind of favorable tax treatment on this year’s tax return.

So what exactly are Qualified Dividends?

If you’ve looked closely at your IRS Form 1040, you’ll notice a line item for Dividend Income, divided into Qualified and Ordinary boxes.

For many people, this is the place they are most likely to dip their toes into the Tax Code Multiverse. There are two income tax codes we all dance with each year: capital gains and ordinary income. Capital gains has fewer brackets: 0%, 15%, and 20%, (with possibly more on the way in the near future). Those brackets are generally lower for most people than ordinary income tax brackets.

A Qualified Dividend has met some requirements outlined in the tax code, which allow it to be taxed at our favorable capital gains rates. That is the current year benefit of Qualified Dividends.

As an aside, that 0% capital gains tax bracket should not be ignored. That is tax-free income you can take each year with proper planning. No Roth IRA or life insurance policy needed. There are also no Required Minimum Distributions in the capital gains universe.

While most people exclusively put long-term savings into IRA and 401(k) accounts, the capital gains tax code is giving all of us a gift that can be easily enjoyed through taxable investment accounts. There are no contribution limits to these accounts the way there are for retirement and other qualified accounts. They also receive a step-up in basis at the death of the account owner, which is a fantastic tax benefit to beneficiaries of the account.

When just about anyone talks (i.e. complains) about taxes, they are talking about ordinary income tax, not capital gains. “The government’s taking half my money!” Not from your capital gains income, they’re not.

A dividend is a distribution of corporate profits to shareholders of the company. Stocks, ETFs, and Mutual Funds can all generate dividends. If you want to search for stocks and funds that do this, search for “income funds,” “income stocks” or “dividend stocks” in your search engine of choice. Generally, the companies that pay dividends are large, profitable, and stable.

But receiving a dividend from a taxable account doesn’t automatically expose you to favorable capital gains tax brackets. How long you hold that stock or fund determines the character of the income.

For mutual funds and ETFs, the basic idea is that the stock must be held in the fund for 61 days for the dividends to be qualified. The rule is actually more complex than that, but it is not the scope of this article to get into what an “ex-dividend” date is, or a what an “unhedged position” is.

The problem with ETF and mutual fund dividends is that the investor has no control over whether an actively managed fund is holding stocks for the required amount of time to qualify for capital gains rates.

Qualified stock dividends are a bit different than fund dividends. If you hold a stock for 60 days (again, the rule is a bit more complex than this), the dividend from that stock will be qualified. In this way, an investor has control over which positions in his or her portfolio are producing income, and how that income will be taxed.

Ordinary Dividends are exposed to the ordinary income part of the tax code. If you have ordinary dividends on your taxes, either you or a fund manager failed to meet the holding period requirement for either a stock or a fund you owned during the year.

You can look at the tax code as a list of incentives for certain behaviors that support the United States economy in ways our government wants it to be supported. Since our economy runs on capitalism, the tax code provides Qualified Dividends as an incentive for people who are investing capital into large businesses and keeping their money invested there.

This mostly benefits large companies, who can afford to pay dividends instead of reinvesting profits into the company. But don’t worry! The tax code provides tax benefits for small businesses, too.

Of course, the rules around all of this are more nuanced and complex than I’m getting into here.

If you are trying to generate more tax-advantaged income from your portfolio, we’re here to help.