Qualified Vs. Non Qualified Dividends
Stock and mutual fund dividends can be divided into two classes for income tax purposes. Qualified dividends are taxed at a lower rate than the tax payer's regular, marginal income tax rate. Non-qualified dividends are taxed as ordinary income at the taxpayer's regular tax rate. Investors should understand whether the dividends they are receiving are qualified or not.
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The Difference
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Qualified dividends are paid by regular corporations. The purpose behind taxing dividends at a lower rate was to reduce the double taxation on corporate profits. A corporation pays taxes on its net earnings. Dividends are paid out of earnings, so when the shareholder pays taxes on dividends earned, the corporate earnings are taxed again. Dividends paid by corporations organized under a section of the tax code that allows the corporation to avoid income tax by paying out the company's income to shareholders will pay non-qualified dividends. These stocks are real estate investment trusts or limited partnerships.
Mutual Funds
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Mutual funds are required to pay out earnings received from the fund's portfolio of securities to shareholders as dividends. A fund's dividends will be qualified or non-qualified based on the type of securities in the fund. A stock fund owning regular corporate stock will pay qualified dividends. A taxable bond fund earns interest from bond that is taxed as regular income, so the dividends from a bond fund will be non-qualified. A fund that specializes in real estate investment trust-REIT-stocks will pay non-qualified dividends because REITs pay non-qualified dividends.
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Significance
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Non-qualified dividends received are considered ordinary income and taxed at the taxpayer's regular tax rate. Qualified dividends are taxed at either 0 or 15 percent. If the taxpayer's marginal tax rate is 25 percent or higher, she pays a 15 percent tax rate on qualified dividends. A taxpayer in a tax bracket less than 25 percent pays zero tax on qualified dividends. A shareholder must own the shares for at least 60 days before the dividend is paid to pay the lower tax rate on qualified dividends.
Identification
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Paid dividends are reported to the shareholder and IRS on the IRS Form 1099-DIV. Each corporation or mutual fund that paid dividends during the year will send out the 1099-DIV to shareholders who received dividends. The 1099-DIV will list qualified and non-qualified dividend amounts in separate boxes. For mutual funds, paid dividends may be a combination of qualified and non-qualified.
Warning
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The law that created the lower tax rates for qualified dividends, the Jobs and Growth Tax Relief Reconciliation Act of 2003, expires at the end of 2010. Starting in 2011 all dividends earned will be taxed as regular income. Shareholders should understand their dividend income may become fully taxable in 2011.
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References
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