The IRS classification of qualified dividends generally leads to a lower tax liability for most taxpayers. Although there are a number of additional steps involved in calculating your total tax in light of the impact of qualified dividends, doing so reduces the amount you owe.
Definition of Dividends
Dividends are typically paid by corporations to their stockholders, and they may be paid as cash, stock or other property. Dividends represent a share of the profit earned by a corporation over a set time period. Dividends are considered income by the IRS and are taxed accordingly. Ordinary dividends are the most common type of payout and are taxed as regular or “ordinary” income at your normal tax rate. Unless a corporation specifies otherwise, dividends are considered to be ordinary.
Some dividend payments fall into a “qualified” category and are subjected to a lower tax rate. Rather than facing taxation at ordinary income rates, qualified dividends are taxed at the much lower rates charged on capital gains -- for most taxpayers, anywhere between 0 and 15 percent. Some restrictions must be met for dividends to be considered “qualified.” First, the dividend must be paid by a U.S. corporation or qualified foreign corporation. Secondly, the dividends must not fall into the IRS’s “not qualified” category, and finally, they must meet the specified holding period.
Qualified dividends that normally fall into the 25 percent tax rate bracket are taxed at 15 percent. If the regular applicable tax rate is less than 25 percent (a factor that is determined by your total taxable income level), qualified dividends are then taxed at 0 percent.
You must own the stock that earns the dividends for more than 60 days of a prescribed 121-day period. That period begins 60 days prior the “ex-dividend date.” The IRS defines the ex-dividend date as “the first date following the declaration of a dividend on which the buyer of a stock will not receive the next dividend payment. Instead, the seller will get the dividend.” The holding period effectively requires taxpayers to commit to longer-term investments, ensuring that any dividends earned fall into the qualified category.
Although calculating the holding period can be confusing, the corporation paying the dividends must report those that are qualified as a special entry on the 1099-DIV form that the corporation provides to both you and the IRS. Qualified dividends are reported in box 1b while ordinary dividends are reported in box 1a of your 1099-DIV.
Reporting Qualified Dividends
Qualified dividends are reported on line 9B of form 1040. The impact of this amount is not calculated until you are determining your tax owed on line 44. Ordinary dividends are entered on line 9A and are added as income to your adjusted gross income.
The IRS provides a multistep worksheet that allows you to determine the rate at which any qualified dividends will be taxed. In essence, after taking several factors, like filing status and total income into account, you subtract qualified dividends from your income and calculate the proper tax rate for them. Then you determine the tax due on your adjusted gross income after subtracting the qualified dividends. Finally, you add the tax due on the qualified dividends to the tax owed on your income (sans the qualified dividends). The sum is your total tax. Calculating the special tax rate on qualified dividends lowers your overall tax liability.
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