What Are Ordinary Dividends?
Ordinary dividends are portions of a company’s profits distributed to its shareholders on a regular basis. One of the key benefits of owning stocks, also known as equities, is receiving this dividend income.
Ordinary dividends are considered the default type of dividend. However, some dividends may qualify as ‘qualified’ if they meet certain criteria. While ordinary dividends are taxed as ordinary income, qualified dividends benefit from lower capital gains tax rates.
Key Takeaways
- Ordinary, or non-qualified, dividends are distributed by corporations to their shareholders.
- By default, dividends are ordinary unless they fulfill special IRS criteria to be classified as qualified.
- Ordinary dividends face taxation as ordinary income, in contrast to qualified dividends, which are taxed at capital gains rates.
Delving Deeper Into Ordinary Dividends
Earnings from dividends fall into two primary categories: qualified and nonqualified (ordinary) dividends. The classification largely depends on the issuing company and how the Internal Revenue Service (IRS) views these payments.
If a dividend isn’t categorized as a qualified payment, it is taxed as ordinary income. To be considered a qualified dividend, the earnings must stem from an American company—or a qualifying foreign company—and should not be listed as an unqualified dividend per IRS guidelines. The earnings must also meet required holding periods:
- A minimum of 60 days for a common stock
- 90 days for preferred stock
- 60 days for a dividend-paying mutual fund
Ordinary dividends can encompass various other dividends or earnings, such as those from real estate investment trusts (REITs). The notable difference between ordinary and qualified dividends lies in their respective tax rates. Ordinary dividends are taxed at the same rate as regular federal income. Companies report such dividends in box 1a of Form 1099-DIV, and mutual fund companies follow the same procedure. You will need to file these earnings on IRS Form 1040, Schedule B, Line 5.
Tax Changes Impacting Dividends
The tax rates for both ordinary and qualified dividends have fluctuated over the years due to legislative changes. In 2003, the Jobs and Growth Tax Relief Reconciliation Act reduced income tax rates and restructured the tax rates on qualified dividends, reducing them to match the lower long-term capital gains rates. This act also reduced the maximum long-term capital gains rate and introduced a favorable rate for those in the lowest income brackets.
In 2005, the Tax Increase Prevention and Reconciliation Act prevented previous provisions from expiring and further reduced the tax rate on qualified dividends and long-term capital gains for low to middle-income taxpayers. Later, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended these benefits.
The American Taxpayer Relief Act of 2012 made qualified dividends permanently part of the tax code but added a higher rate for top income brackets. Tax brackets are adjusted for inflation each year.
As of 2021, the maximum tax rates are 20% for qualified dividends and 37% for ordinary dividends. The 2017 Tax Cuts and Jobs Act, initiated by President Trump’s administration, had minimal impact on taxes for dividends and capital gains.
Ordinary Dividends: A Practical Example
Imagine an investor named John who holds 100,000 shares of XYZ Corporation, which pays a dividend of $0.20 per share annually. In total, John receives $20,000 in dividends each year from XYZ Corporation.
Since XYZ does not pay qualified dividends, John is required to pay the regular income tax rate on these dividends, as opposed to the capital gains tax rate.
Related Terms: equities, capital gains, IRS, Form 1099-DIV, mutual funds, REITs
References
- Internal Revenue Service. “Publication 550-Investment Income and Expenses (Including Capital Gains and Losses”, Pages 18, 20.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses (Including Capital Gains and Losses”, Pages 19-20.
- Internal Revenue Service. “Instructions for Form 1099-DIV (Rev. January 2022)”, Pages 2-4.
- Internal Revenue Service. “2021 Instructions for Schedule B-Interest and Ordinary Dividends”, Page 2.
- Library of Congress. “H.R.2 - Jobs and Growth Tax Relief Reconciliation Act of 2003”.
- Library of Congress. “H.R.4297 - Tax Increase Prevention and Reconciliation Act of 2005”.
- Library of Congress. “H.R.8 - American Taxpayer Relief Act of 2012”.
- Internal Revenue Service. “Topic No. 409 Capital Gains and Losses”.
- Library of Congress. “H.R.4853 - Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010”.
- Internal Revenue Service. “IRS Provides Tax Inflation Adjustments for Tax Year 2021”.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses (Including Capital Gains and Losses)”, Page 19.
