• American Financial Partner

What Are Nonqualified Dividends?

Updated: Sep 7, 2021

A look at what dividends don't qualify for a lower tax rate.

Most dividend payments are taxable. However, the tax rate varies significantly depending on the type of dividend (qualified vs. nonqualified) and an investor's tax bracket. The highest rates come from nonqualified dividends paid to investors in higher tax brackets. Because of that, investors need to know what types of income stocks they own so that they're aware of the tax consequences.

What are nonqualified dividends?

A nonqualified dividend is one that doesn't meet the IRS's requirements to qualify for a lower tax rate. These dividends are also known as ordinary dividends because they get taxed as ordinary income by the IRS. Nonqualified dividends include:

  • Those paid by certain foreign companies. A foreign company's dividends may be disqualified if it isn't part of a comprehensive income tax treaty with the U.S. or its stock isn't readily tradable on an established U.S. securities market (such as Nasdaq or NYSE). Also, dividends from passive foreign investment companies aren't qualified.

  • Distributions from certain U.S. entities, such as real estate investment trusts (REITs) and master limited partnerships (MLPs).

  • Dividends paid on employee stock options.

  • Special one-time dividends.

  • Dividends that don't meet the IRS's minimum holding period to qualify for a lower tax rate. Common stock investors must hold shares for more than 60 days during a 121-day period that starts 60 days before the ex-dividend date or the day after the dividend payment. Meanwhile, the holding period for preferred stock dividend is more than 90 days during a 181-day period that starts 90 days before the ex-dividend date.

What are the tax rates on nonqualified dividends?

The primary drawback of nonqualified dividends is that the IRS taxes them at higher rates than qualified ones. For the tax year 2020, the IRS taxes nonqualified dividends at the same rate as an investor's ordinary income tax rate.

For comparison's sake, the tax rate on qualified dividends is either 0%, 15%, or 20% depending on an investor's tax bracket. Because of this difference, investors pay substantially more in taxes on nonqualified dividends.

However, dividend tax rates matter only for stocks held directly or in a regular brokerage account. Dividends paid on stocks owned in a traditional IRA aren't taxed when paid or reinvested, though an investor does pay taxes at their current income tax rate when they withdraw funds during retirement. Meanwhile, dividend payments on stocks held in Roth IRAs are completely tax-exempt, meaning all current and future dividend payments (qualified or nonqualified) aren't taxable. Because of this distinction, it often makes sense to hold nonqualified dividend payers like REITs in an IRA.

Examples of nonqualified dividend stocks

Most dividends paid by U.S. corporations qualify for a lower tax rate. However, one of the qualifiers is the minimum holding period. If an investor doesn't meet that requirement, the first payment won't qualify for the lower tax rate. Because of that, investors should make sure that they'll meet this minimum so that they can qualify for a lower tax rate.

Another factor that can disqualify a dividend from a lower tax rate are those paid on employee stock options. That's because stock options are typically a form of compensation. Thus, the IRS sees the dividend paid by that option as income, which it then taxes according to the recipient's tax bracket.

An important qualifier for a lower tax rate is the type of company paying a dividend. For example, REITs, certain foreign companies, and MLPs don't qualify for lower tax rates. Because of that, investors should consider holding a REIT or the foreign stock in a tax-advantaged account like an IRA.

Unfortunately, that's not an option for an MLP, since most brokers won't allow investors to hold them in an IRA because they're already tax-advantaged. However, investors can consider alternatives if they want to avoid paying a higher tax rate on these entities. For example, while many energy midstream companies are MLPs and pay nonqualified dividends, others have chosen to be taxed as regular corporations. Thus, an investor can choose to invest in one of those comparable corporations instead of an MLP if taxes are a major consideration.

Finally, investors in higher tax brackets should be aware of companies that routinely pay special dividends, since those are usually nonqualified payments. Because of that, high-wage earners might want to consider holding companies known for special dividends in an IRA instead of their regular brokerage account.

Know the dividend type before making an investment

The tax rate on a nonqualified dividend can be as high as 37%, which is well above the 20% cap on qualified payments. Because of that, investors in higher tax brackets should make sure a stock's dividend will qualify for the lower tax rate before making that investment, since it could save them money come tax time. You need to pay attention to your holding period and whether the company qualifies, which can dictate whether to hold off on making the purchase or buying shares in a tax-advantaged account.

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