What is Dividend Investing and What are Qualified Dividends?

Highlights:

• Dividend investing refers to the practice of buying stocks from companies that offer regular dividend payouts to their shareholders.
• Dividends are classified as either qualified or ordinary, which describes the way the dividends are taxed by the IRS.
• Companies that pay dividends tend to be large and relatively stable, making them reliable options for a portfolio — but remember that all investment involves some level of risk.

If you're looking for a new addition to your investment portfolio, you might consider dividend stocks. Learn all about how dividend investing works and how to spot the difference between ordinary and qualified dividends.

What is dividend investing?

Some companies offer an enticing reward to their shareholders: regular payments known as dividends. Dividends are portions of corporate profits paid to shareholders in the form of cash or additional stock shares.

Dividend investing refers to the practice of buying stocks from publicly traded companies that offer regular dividend payouts. The return from these stocks is often twofold: first, there's capital appreciation, which occurs when the stock's market price increases over time. Second, there are the regular dividends that the company pays.

For example, imagine you own 150 shares of dividend stock, trading at $100 per share. If these stocks have a 2% annual dividend yield, you'll receive 2% of $100, or $2 per share. So, your 150 shares will earn $300 in dividend payments over the course of a year.

How does dividend investing work?

Dividend stocks are usually offered only by large, financially stable companies. This is because smaller businesses are more likely to reinvest excess money in order to grow, rather than disbursing it to shareholders.

Dividends are controlled by a company's board of directors, which announces the dividend payment — expressed as a percentage per share — on the declaration date.

Once the dividend amount is set, the company will then determine the record and ex-dividend dates. The record date is the day the company prepares a list of all current shareholders who will receive the next dividend payout. The ex-dividend date is the cutoff for investors to qualify to receive the dividend, and it's almost always one business day before the record date.

If you purchase stock on or after the company's ex-dividend date, you won't receive the current dividend. However, you will generally be eligible for future dividends.

Dividends are typically paid quarterly and are automatically deposited into the investment account where the qualifying stock is held.

What are ordinary and qualified dividends?

Dividends are classified as either ordinary or qualified, which describes the way they are taxed by the IRS. Ordinary dividends are taxed at the same rate as salaries, tips, bonuses, commissions, interest income and other types of ordinary income. Qualified dividends, on the other hand, are taxed at lower capital gains rates, which are divided into three progressive tiers: 0%, 15% and 20%.

Investors qualify for one of these rates according to their adjusted gross income. The exact income limits can change every tax year, but generally lower earners are taxed at 0%, middle earners at 15% and higher earners at 20%.

How do I know if my dividends are qualified or ordinary?

In order to determine whether your dividends are qualified or ordinary, you'll need to consider the company's ex-dividend date. That's because qualified dividend stocks have a holding period requirement.

In order for a stock to be considered qualified (and taxed at a lower rate), you must purchase and hold it for longer than 60 days during the 121-day period beginning 60 days before the ex-dividend date. If you purchase your stock after the ex-dividend date, you will receive ordinary dividends.

Although these tax rules may confound you at first, they directly affect how much you'll owe to the IRS at tax time. If you own dividend stocks and receive payments in a given tax year, you can find the status of your dividend on the IRS Form 1099-DIV that banks, investment companies and other financial institutions are required to provide. Box 1a lists your ordinary dividends, while your qualified dividends will appear in box 1b.

What are the benefits of dividend investing?

Now that you have a basic understanding of dividend investing, you may be wondering why dividend stocks are such a prominent component of many portfolios.

First, because a significant amount of revenue is necessary to pay shareholder dividends, organizations that offer dividends tend to be older, larger institutions. These companies may be more financially stable than smaller, newer businesses, even when the market shifts downward.

Investors also find it difficult to resist a reliable stream of income. Dividends, though not guaranteed, provide an opportunity to earn extra money, all without having to sell your shares. You can even reinvest your dividends to compound your earnings.

However, dividend stocks aren't without drawbacks. Companies occasionally discontinue dividends in response to financial stress. And just like other kinds of investments, dividend stocks can lose value if the market takes a nosedive.

Remember: While dividend stocks can be a solid investment option, all investments involve some amount of risk. So, if you're considering purchasing dividend stocks, remember to research your options carefully before taking the leap.