One of the things most taxpaying adults realize early on is that tax law is really confusing. Nothing is every straight-forward or simple, which is why most people fear doing their taxes even when it’s a “simple” two-page 1040-EZ form! For the longest time, I didn’t invest outside of my Roth IRA and 401(k) because I didn’t want to deal with the taxes (and I didn’t have much money to invest). Fortunately, I’ve since learned that the taxes aren’t that complicated, as long as you keep good records, but one area that has confused me a little was the topic of qualified dividends versus ordinary dividends.
When you get a dividend from a company or a mutual fund, you need to find out if it’s an ordinary or qualified dividend. If it’s a qualified dividend, it “qualifies” for the lower tax rates of long term capital gains. If it’s an ordinary dividend, it’s taxed at your ordinary income tax rate . That’s the main difference that matters to you and me.
Qualified Dividend Rules
There are three rules for qualified dividends:
- The dividend is paid by an American company or a qualifying foreign company (like an ADR).
- The dividends aren’t on file with the IRS as dividends that are not qualified.
- You’ve met the required dividend holding period of 60 days (in the 120 day window before and after the ex-dividend date ) for favorable tax treatment.
When in doubt, do you research to find out whether or not a dividend is qualified. One prime example of a dividend that isn’t qualified but seems to satisfy rules 1 and 3 is that of a master limited partnership (MLP). MLPs are curious tax creatures that get special treatment because they are partnerships, rather than corporations. They pass long their income to their partners as ordinary income. What makes them curious is that an MLP can specify a percentage of each distribution as “shielded” from income taxes and that amount is to be used to lower your cost basis. If you owned 100 shares of an MLP at $100 a share and they distributed $1,000 with $500 of that as shielded, you would reduce your cost basis of your shares by $500 (or $5 per share). This is why MLPs offer the ability to defer your taxes (and presumably, you could hold it for more than a year and get favorable tax rates on the “dividend.” (I’m not an MLP expert nor do I own any, so this is merely my interpretation of how it works)
Reading a 1099-DIV
A mutual fund company will usually send you a 1099-DIV to explain the tax treatment of your dividends, some of which will be ordinary dividends and some of which will be the coveted qualified dividends. The form is confusing because it’ll lump ordinary and qualified dividends together as ordinary dividends and then separately list qualified dividends. For example, if you received $500 in ordinary dividends and $500 in qualified dividends, the 1099-DIV will report $1,000 of ordinary dividends and $500 of qualified dividends. You didn’t get $1,500, it’s just the quirky way in which the dividends are reported.
One other rule to be aware of is that the required holding period still applies. If you hold a mutual fund for fewer than 61 days, none of the reported dividend is considered qualified, even if the mutual fund reports it as a qualified dividend. The fund didn’t keep track of how long you held the shares so they are unable to determine, on your behalf, whether it was actually qualified.
So when you go out to purchase shares in a company because you like the dividend, do a little more research to find out if the dividend is qualified.
(Photo: chrisbrooks )