A dividend can be a great source of supplemental income. Similar to other sources of income, a dividend is considered taxable by the Internal Revenue Service (IRS). Depending on how the dividend is categorized, ordinary or qualified, will determine whether the dividend will be taxed at the ordinary tax rate for the taxpayer or at the capital-gains tax rate.
The IRS defines a dividend as any distribution of cash, stock(s) or other property paid from a corporation to its shareholders. A dividend is an optional payment made to shareholders by financially stable corporations to entice potential investors to purchase their stock.
A dividend is more than a source of income for an investor. Lawrence J. Gitman, author of "Principles of Managerial Finance," says, "[Dividends] contain useful information about the firm's current and future performance. Such information affects the shareholders’ perception of the firm's risk.” Corporations that are in their high-growth phase tend to reinvest retained earnings to further the growth and expansion. Therefore, dividends do not get paid out to shareholders. More mature and financially stable corporations, however, do not reinvest as much for growth, and, as a result, these corporations will often pay dividends to shareholders.
Types of Dividends
There are two common types of dividends: cash and stock. A cash dividend is the most common type of dividend. When a corporation issues a cash dividend, each shareholder receives a cash payment based upon the number of shares owned. In a stock dividend, the shareholder receives from the corporation additional stock, once again, in proportion to the number of stocks the shareholder owns.
Most dividends are categorized as ordinary and will be “taxable as ordinary income," reports the IRS. A new type of dividend, a qualified dividend, was created when President George W. Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003. This legislation, in effect through 2010, created a tax break for investors. After meeting specific requirements, a dividend can be categorized as a qualified dividend and enjoy a lower tax rate, states Fidelity.com. The lower tax rate is the same as the capital-gains tax rate -- 15 percent (or 5 percent for the lower two tax brackets).
Requisite Holding Period
Qualified dividends don't automatically qualify for the lower tax rates. There is a holding period requirement. A good tax preparation program or a qualified tax preparer can help determine whether the requirement has been met. Roy Lewis, contributor to The Motley Fool at Fool.com, says, "You're required to hold the [common] stock for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date." For preferred stock, "The holding period is 90 days during the 180-day period beginning 90 days before the stock's ex-dividend date."
When a dividend is declared by a corporation, a record date is set. Once a record date has been established, the stock exchange on which the stock is actively traded will set an ex-dividend date. This is normally two business days prior to the record date. Whoever owns the stock on the ex-dividend date will receive the dividend. According to the holding period requirements, a common stock shareholder must hold that stock for 61 days (including the ex-dividend date) during the period specified previously. Preferred shareholders must hold their stock(s) for 91 days, respectively.
Before investing, discuss your current and future financial needs with a qualified financial planner. It is not wise to invest money that you cannot afford to lose without being fully aware of all risks and options.