Posted on March 26th, 2014

Dividends are taxed at the same favorable 0%, 15%, or 20% rates that apply to long-term capital gain, for purposes of both the regular tax and the alternative minimum tax—but only if the dividends are “qualified dividend income.” Dividends that aren’t qualified are taxed as ordinary income, at rates as high as 39.6%.

Starting in 2013, there will also be a 3.8% tax on net investment income, which applies to taxpayers with modified adjusted gross income (MAGI) that exceeds $250,000 for joint returns and surviving spouses or $200,000 for single taxpayers and heads of household. After the 3.8% tax is factored in, the top rate on capital gains and qualified dividends is 23.8%.

Qualified dividend income generally means dividends received during the tax year from domestic corporations or from qualified foreign corporations, which include U.S. possessions corporations, foreign corporations whose stock is traded on established U.S. securities markets, and foreign corporations eligible for income tax treaty benefits.

However, in order to treat a dividend as qualified dividend income, you must hold the underlying stock for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date. If the dividend was declared on preferred stock and is attributable to a period of more than 366 days, you must hold the underlying stock for at least 91 days during the 181-day period beginning 90 days before the ex-dividend date.

Qualified dividend income does not include the following:

(1) dividends on any share of stock to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property, for example, in connection with a short sale;

(2) any payment in lieu of dividends, for example, payments received by a person who lends stock in connection with a short sale;

(3) dividends that you elect to treat as investment income for purposes of the rules governing the deduction of investment interest;

(4) dividends from a tax-exempt charitable, religious, scientific, etc., organization, religious or apostolic organization, qualified employee trust, or farmers’ cooperative;

(5) deductible dividends paid by mutual savings banks, etc.;

(6) deductible “applicable dividends” paid on “applicable employer securities” held by an employee stock ownership plan (ESOP);

(7) dividends received as a nominee.

Mutual fund dividends. The qualified dividend income rules discussed above apply to dividends on stock that you own, directly or through a brokerage account. What about dividends from mutual funds? If you own shares of a mutual fund that holds dividend-paying stock, and if you meet the holding-period requirements discussed above with respect to those mutual fund shares, then, to the extent that the dividends received by the mutual fund are qualified dividend income, you are entitled to treat the dividends you receive from the mutual fund as qualified dividend income, taxable at the 0%, 15%, or 20% maximum rates. The mutual fund should notify you, by means of Form 1099-DIV, how much of your income from the mutual fund is eligible for qualified dividend income treatment.

Dividends received by other pass-thru entities. In addition to mutual funds, you may have interests in other types of “pass-thru” entities that receive qualified dividend income that’s “passed through” to you—such as partnerships, S corporations, estates, trusts, and real estate investment trusts (REITs). By and large, you may treat your share of the qualified dividend income of these entities as qualified dividend income. As in the case of mutual funds, these entities should notify you, on the appropriate form, how much of your share of their income is eligible for qualified dividend income treatment.

Effect of capital losses on dividends. While qualified dividend income is taxed at the same rates as long-term capital gain, it isn’t actually long-term capital gain. Therefore, you can’t use capital losses that otherwise enter into the computation of your taxable “net capital gain” (the excess of net long-term capital gain over net short-term capital loss) to offset your qualified dividend income. As a result, generally, your qualified dividend income will be taxed in full at the 0%, 15%, or 20% rates.

However, if your capital losses exceed your capital gains for the tax year, the excess, up to $3,000, can be used to offset other income. This offset can be used against qualified dividend income, but only after it’s been used against taxable income other than qualified dividend income. However, this “ordering” rule is actually a benefit, because offsetting taxable income other than qualified dividend income, which is taxable at rates up to 39.6%, saves more tax than offsetting qualified dividend income, which is taxed at no more than 20%.

Planning. The taxation of dividends at the favorable 0%, 15%, and 20% rates may make investments in dividend-paying stock significantly more advantageous than investments that produce income taxed at rates as high as 39.6% (for example, rental real estate, or any type of investment that produces taxable interest). If you have any questions on whether any of your dividend income is qualified dividend income, or if you would like to discuss some planning strategies with me, please call.