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Regular dividends versus authorized dividends

Regular dividends versus authorized dividends

Dividends paid to investors by companies are of two kinds – ordinary and qualified – and the difference has a big impact on the taxes that will be owed. Common dividends are taxed as ordinary income, meaning an investor must pay federal income taxes at the individual’s ordinary rate. Authorized dividends, on the other hand, are taxed at capital gains rates. Dividend recipients with lower income may owe no federal tax at all. A financial advisor can help you find a variety of securities that best meet your needs.

Dividends from holding company shares can be classified as qualifying dividends and are eligible for the lower capital gains rate if the investor has held them for a minimum period. Dividends received from certain sources, including real estate investment trusts (REITs) and money market mutual funds, are generally classified as common dividends regardless of how long they have been in a portfolio.

Regular Dividends vs. Authorized Dividends: The History

Before 2003, all dividends were joint dividends and their recipients paid tax at the usual individual marginal rate. However, the tax cut law enacted that year created a new qualified dividend exception as a way to encourage companies to pay dividends on their stock. Since then, the opportunity for favorable tax treatment has made dividends a greater focus for both companies and investors.

What are Qualified Dividends?

Regular dividends versus authorized dividends

Regular dividends versus authorized dividends

Regular dividends paid on shares of domestic companies are generally considered conditional on the investor holding the shares for a minimum period. The Internal Revenue Service rule says that the shares must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. For preferred stock, the stock must be held for more than 90 days during the 181 days beginning 90 days before the ex-dividend date.

The ex-dividend date is the earliest date after the dividend is declared that the purchaser of the dividend will not be entitled to receive the declared dividend. Shares must also be unhedged during the holding period. This means that the investor cannot have used short puts, puts or calls on the shares during the holding period.

If the dividends meet the definition of qualified, then the investor will not owe tax on the income in excess of 20%. This top rate only applies to high income earners whose marginal tax rate is a maximum of 37%. Filers whose marginal rate is less than 37% but at least 15% will owe 15%. Filers whose income would be taxed at 10% or 15% will owe no federal income tax.

What are ordinary dividends?

Most dividends from a company or mutual fund are ordinary dividends and are taxed like ordinary income, at the investor’s usual marginal tax rate. There are some businesses whose dividends are treated differently and their dividends are always or almost always classified as ordinary income.

These dividend payers include:

  • Money market funds

  • Banks, savings and similar institutions that pay interest on deposits

  • Real estate investment trusts

  • Master limited companies

  • Employee stock ownership plans

  • Foreign companies

How to use Form 1099-DIV

It is not necessary for taxpayers to figure out for themselves which dividends are common and which are appropriate. Dividend payers do this for them and report the information to taxpayers as well as the IRS using Form 1099-DIV.

For planning purposes, it’s still a good idea for investors to have an idea ahead of time whether dividends will be treated as qualified or ordinary. For example, it’s often a good idea to hold ordinary dividend-producing securities in a taxable account like an IRA or 401(k).

Conclusion

Regular dividends versus authorized dividends

Regular dividends versus authorized dividends

The IRS rules regarding the classification of dividends as common or special are complex, and it can be difficult for dividend investors to tell, before they receive a Form 1099-Div, how their dividend income will be taxed. Common dividends are taxed as ordinary income at an individual investor’s normal marginal tax rate. Qualified dividends are taxed at the lower capital gains rate.

The length of time an investor has owned a security helps determine whether its dividends will be treated as common or qualified. In general, if a stock has been held for more than a few months, its dividends are likely to qualify. Exceptions include certain dividend-paying securities, such as REITs and money market funds.

Investment advice

  • A financial advisor can help you determine whether a dividend will be classified as qualified or ordinary and provide advice on how to manage the taxes that will be due on the income. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors serving your area, and you can interview your advisors at no cost to decide who is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

  • Income in America is taxed by the federal government, most state governments, and many local governments. The federal income tax system is progressive, so the tax rate increases as income increases. A free federal income tax calculator can give you a quick estimate of what you owe Uncle Sam.

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