Owning stocks or mutual funds gives you two ways to make money. When the shares you buy go up in price, you can sell them for a profit. However, many investments also distribute the money that they make to their owners as cash or stock dividends. Dividends are taxable, but some qualify for favorable tax rates.
Ordinary vs. Qualified Ordinary Dividends
If a company or fund distributes a portion of its profits to you as a dividend, the IRS considers it an "ordinary" dividend, and the company that pays it to you reports its value on box 1a of the 1099 form they send you after the end of the tax year. However, some ordinary dividends are also qualified. Qualified ordinary dividends get special tax treatment and get separately reported on box 1b of your 1099. To be qualified, you need to hold the stock for at least 60 of the 121 days before the company announces it'll be paying a dividend, and you need to own it outright without any hedging that might protect your risk. The company also needs to be U.S. based or a foreign company that meets the IRS' guidelines.
Ordinary Dividend Tax
Ordinary dividends are taxed as regular income. If your marginal tax bracket, which is the rate you pay on your first dollar of additional income, is 25 percent, then your ordinary dividends are subject to 25 percent tax. As your income goes up, the tax on your ordinary dividends goes up, as well. To calculate your tax liability, multiply your ordinary dividends by your tax rate. For example, if you have $2,500 in dividend income and you're in the 25 percent bracket, you'll owe $625 in federal tax on them.
Qualified Ordinary Dividend Tax
Qualified ordinary dividends receive special tax treatment which is much more favorable than ordinary dividend tax. As of the date of publication, if your marginal income tax rate is 25 percent or less, qualified dividends are non-taxable. If your marginal rate is 25 percent or more, you pay the same tax rate you would on long-term capital gains -- 15 percent. For example, $2,500 in qualified dividends would carry either $0 or $375 in federal tax.
As your income grows, you can fall subject to additional taxes. Single people with adjusted gross incomes over $200,000 or married couples with AGIs above $250,000 pay an additional 3.8 percent surtax on income above those thresholds, which raises ordinary dividend rates with your income tax rate and increases qualified ordinary dividend taxes to 3.8 or 18.8 percent. People over $400,000 or $450,000 for couples pay 23.8 percent tax on their qualified ordinary dividends.
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