Ordinary dividends are a key financial concept for investors, representing a share of a company's profits that is distributed to its shareholders on a periodic basis. For many investors, one of the primary benefits of owning stocks (also known as equities) is the potential for earning regular dividend payments. This article delves into what ordinary dividends are, how they are taxed, and how they differ from qualified dividends.
Key Takeaways
- Ordinary dividends, also referred to as non-qualified dividends, are payments made by corporations to shareholders of record.
- By default, dividends are considered ordinary unless they meet specific criteria set forth by the IRS to qualify as "qualified."
- Taxation on ordinary dividends occurs at ordinary income tax rates, while qualified dividends benefit from lower capital gains tax rates.
What Are Ordinary Dividends?
Ordinary dividends are straightforward — they are distributed profits from a corporation to its shareholders. This kind of dividend payment is rooted in the company's financial health and profitability, and it rewards shareholders for their investment.
The Tax Implications
Ordinary dividends can be categorized into two groups: qualified dividends and ordinary dividends. The primary difference here is the tax treatment of these two categories:
- Ordinary Dividends: Subject to ordinary income taxation rates, which can be as high as 37% for certain tax brackets.
- Qualified Dividends: Taxed at capital gains tax rates, which are generally lower. The maximum rate on qualified dividends is currently 20%, with possible exceptions for taxpayers in lower brackets.
To be categorized as qualified dividends, several criteria must be met: - The dividend must originate from a U.S. corporation or a qualified foreign corporation. - The dividend must not be listed as unqualified according to IRS guidelines. - Shareholders must adhere to specific holding periods: - At least 60 days for common stock. - 90 days for preferred stock. - 60 days for dividend-paying mutual funds.
Types of Income Associated with Ordinary Dividends
Ordinary dividends can encompass various types of income, including: - Dividends from Real Estate Investment Trusts (REITs): These earnings are generally considered ordinary and are taxed at the highest rate. - Distributions from Mutual Funds: Similar to corporations, mutual funds report dividends on Form 1099-DIV.
Reporting Ordinary Dividends
Investors receive a Form 1099-DIV from companies declaring dividends, which provides necessary information for tax reporting. Ordinary dividends are reported in box 1a of this form and must be included as income on IRS Form 1040, Schedule B, Line 5 during tax filing.
Historical Context and Tax Changes on Dividends
The distinction between ordinary and qualified dividends is not static and has been shaped by various tax legislations over the years. Key laws influencing dividend taxation include:
- Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA): This act lowered the maximum rate on qualified dividends from ordinary income rates to capital gains rates.
- Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA): Extended prior provisions for two additional years and adjusted rates for low to middle-income taxpayers.
- American Taxpayer Relief Act of 2012: Made qualified dividends a permanent part of the tax code, instating a maximum tax rate of 20% for certain income brackets.
- Tax Cuts and Jobs Act of 2017: This legislation made minimal changes to the taxation of dividends but maintained existing capital gain rates.
Example of Ordinary Dividends
To illustrate how ordinary dividends work, consider Joe Investor, who owns 100,000 shares of Company ABC which pays a $0.20 dividend per share annually. This totals to:
Dividend Income = Number of Shares x Dividend per Share
Dividend Income = 100,000 x $0.20 = $20,000
Joe therefore receives $20,000 in ordinary dividends each year. Since these dividends do not qualify as capital gains, Joe must pay income tax on this amount at his applicable ordinary income tax rate.
Conclusion
Ordinary dividends are a significant aspect of equity investing, providing not only a form of income but also a reflection of a company's financial performance. Understanding the tax implications and classification of dividends can help investors make more informed decisions regarding their portfolios. As always, investors should consult tax professionals for personalized advice concerning their specific situations.