Dividend Taxation

How are dividends taxed?

Dividends are treated in one of two ways.  Ordinary dividends are treated just like any other income, such as salary your job.  In that case, they’re taxed at whatever your ordinary tax rate is.  They could also be treated as qualified, which allows them to be treated at lower tax rates (currently 0%, 15% or 20%, depending on your income level).

What are qualified dividends?

The government has three rules to determine whether a dividend you received can be considered qualified, and thus eligible for the lower tax rate.

  1. It must be from a US company, or a qualifying foreign company.  If you buy a stock that is trading on the NYSE or Nasdaq you don’t need to worry about this rule too often.
  2. It must not be specifically excluded by the IRS.  These are mostly Real Estate Investment Trusts (REITs) and money-market account dividends. If you buy a regular common or preferred stock you’ll satisfy this rule.
  3. It must satisfy the holding period requirements.

Rule #3 is what affects most taxpayers, so let’s discuss that in more detail

What are the holding period requirements? 

To qualify for the lower tax rates, you must hold the investment for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date.  Basically, just picture a 60-day window on both sides of the ex-dividend date: you need to hold a security for at least 60 days during that period to qualify. (Note: for preferred stock investments, the periods are 90 and 181 days, respectively).  This rule is intended to prevent investors from just scooping of shares of companies the day before the ex-dividend date and then selling them off again when they receive the cash.  The tax code incentivizes long-term investing, and the holding period requirement ensures that to receive the beneficial rates you need to actually hold on to the security for a slightly more substantial amount of time.

What do I need to do?

The good news is that if you’re buying and selling your investments through a reputable broker, they’re going to track the holding periods and make sure your investment qualifies for you.  So you don’t need to keep detailed notes or mark on your calendar when you purchased each security. But even though they’re doing the heavy lifting, it’s still important you know the rules, so you don’t accidentally un-qualify yourself. For example, don’t sell a security after 58 days when holding it slightly longer will grant you a better tax rate. You’ll also want to consider the rule when computing your ROI for different securities: if you’re comparing a REIT and common stock and they both have the same stated dividend, you may have a better after-tax return with the latter.