Dividends are taxed differently, depending on their classification of being ‘qualified’ or ‘ordinary’.
Dividends are cash distributions from a company who has excess cash flow and distributes these profits to their shareholders. Ordinary dividends are taxed as ordinary income while qualified dividends are eligible for the preferential long-term capital gain tax-rate treatment. Most taxpayers are in the 15% tax bracket for long-term capital gains versus average ordinary income tax bracket of 24%.
What constitutes a qualified dividend, you ask? Great question and it depends on how long you have owned or ‘held’ the stock, aka ‘Holding Period’ and whether it is a US firm. To be ‘qualified’ you must have owned the stock for more than 2 months in the past 4 before the dividend has been announced (aka ‘declared’, or ‘traded X’).
The reasoning behind having a lower-tax rate for some dividends is that the company (having US ties) already paid taxes on these profits and to encourage investors to hold securities rather that be speculators, such as day-traders. This legislation was a result of George W Bush’s Jobs & Growth Tax Relief Reconciliation Act passed in 2003.
Regardless, if you anticipate having ordinary income treatment on your dividends then consider holding these stocks or mutual funds in a tax-deferred account as opposed to a taxable brokerage account.