Updated: Sep 5, 2021
What are qualified dividends? How are they different from ordinary dividends? These are questions new dividend investors normally ask. It all comes down to dividend taxation or how this income is taxed. This applies to those who aren't using 401Ks or other tax advantaged accounts. This article is for US taxable brokerage accounts.
How the heck do taxes work in my taxable account?
First, off we’ll talk about selling a stock for profit. When you sell a stock for profit you are earning "capital gains". Capital gains fall into two categories:
If you held the stock for shorter than one year, you will pay short term capital gains at your federal income level. (10%-37%)
If you held the stock longer than a year, you will be taxed at the long term capital gains rate based on your income and filing status (0%, 15%, or 20%)
Your brokerage account will usually list your the stock as a short or long position inside your portfolio which is referring the periods above. This should not be confused with shorting a stock, which is whole other article. Below is an example from my portfolio which shows my Apple Stock ($AAPL) shares with both long and short stock positions. For example, the two Apple shares purchased on November 11 2020 will turn into a long position on the same date in 2021.
Dividend distributions are broken down into two main types (not including special dividends):
Qualified Dividends: These are taxed as long term capital gains. So, the taxes are based on the federal income tax rates at 0%, 15%, or 20% depending on your income. Most dividends fall into this category. There is a holding period required for you to get qualified dividends. This is straight from the IRS website: “Common stock investors must hold the shares for more than 60 days during the 121-day period that starts 60 days before the ex-dividend date, or the date after the dividend has been paid out and after which any new buyers would then be eligible to receive future dividends. For preferred stock, the holding period is more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.”
Ordinary Dividends: These are taxed at your federal income tax bracket just like short term capital gains. Ordinary dividends I’ve seen come from three main sources. Not holding the stock per IRS guidelines, REITs, and Covered Call ETFs but there are others.
Your brokerage account will list which type of dividend you received. As you can see below I received qualified dividends in $AAPL, $GD, $ORCL, and $CSCO. I also received ordinary dividends in $JEPI and $O. The negative numbers are my brokerage's automatic dividend reinvestment plan (DRIP) that I set up to use my dividends to immediately repurchase more shares.
You can also use a website like dividend.com to tell you if a company pays qualified or ordinary dividends. Below is an example of Apple Stock ($AAPL).
If you are in a taxable account it is important to understand the taxes and how they apply to your dividends. You will owe those taxes at the end of the year. Your broker will provide tax paperwork to use when you file your taxes but they aren't going to pay your taxes automatically like an employer does. That's up to you. I fall into the 22% tax bracket so I set aside that much in my bank account each month to cover the dividends I received. Once I start earning more than I do now I plan to transfer a portion of my dividends from brokerage account to my bank account each month to cover my anticipated taxes. To calculate how much you will earn in dividends per year you'll need to use your stock's dividend yield. Remember, yield isn't the only factor to consider when choosing stocks. Taxes can have large impact on your returns and need to be accounted for.
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