The key difference between ordinary and qualified dividends is the tax rate you'll pay on them

In addition to regular income tax, your ordinary dividend payments may be subject to the Net Investment Income Tax. MoMo Productions/Getty

• Ordinary dividends are payments made to shareholders that are taxed at the same rate as their regular income.
• Qualified dividends are taxed at a lower capital gains rate of no more than 20%.
• Most dividends from stock in US companies held for more than 60 days will pay qualified dividends.

Many investors purchase shares of stock in companies that pay dividends, or payments made directly to shareholders as a portion of profits. For some, dividend investing is part of a strategy to produce steady income.

Investors earn either ordinary or qualified dividends, which affects taxation. Here are the primary differences between the two types of dividends — and how you might invest in them.

Ordinary dividends vs. qualified dividends: At a glance

Investors like both ordinary and qualified dividends for the cash flow they earn based on company profits. The key difference between ordinary and qualified dividends is the rate at which they are taxed. 

• Ordinary dividends are payments made to shareholders that are taxed at the same rate as their ordinary income. 
• Qualified dividends have a lower capital gains tax rate of no more than 20%.

What are ordinary dividends?

Ordinary dividends factor into your overall taxable income, and thus are taxed at your ordinary income tax rate, which tops out at 37% for the highest earners. The IRS requires you to report taxable ordinary dividend amounts above $1,500 on Schedule B of Form 1040 . 

Ordinary dividends provide steady revenue without the need to sell shares of stock. In this way, investors gain short-term and long-term benefits. 

Investors can offset the higher tax rate by keeping the related securities in a tax-advantaged retirement account such as traditional IRA or 401(k), thus delaying the point when taxes will be due. 

"By locating these securities inside a traditional retirement account, the investor gets to defer the taxable event from when the ordinary dividend is paid to when it is later withdrawn," says Sean Mullaney, a certified public accountant and financial planner at Mullaney Financial & Tax.

With a Roth IRA or Roth 401(k), you can pay the tax now and make tax-free withdrawals after retirement.

Ordinary dividend example

Let's say you're an individual earning $41,775 of taxable income annually with an additional $500 in quarterly ordinary dividends, or $2,000 total. For 2022, you'd pay 10% in taxes on the first $10,275 ($1,027.50), then 12% on the amount over $10,275 ($3,780). 

Remember that not all income is taxed at the same rate. There US has a progressive income-tax system with seven tax brackets ranging from ranging from 10% for the lowest income levels up to 37%. Different chunks of your income are taxed at rates that get gradually higher as the total amount increases. Dividend income is taxed using the same system.

Note: In addition to regular income tax, your dividend payments may be subject to the Net Investment Income Tax. The NIIT is 3.8% for single filers earning $200,000 or joint filers earning $250,000 annually in modified adjusted gross income (AGI).

For this example, your taxes on dividends would be $440, although all ordinary dividends increase your taxable income and can increase your overall tax bill. Here are some pros and cons:

What are qualified dividends?

Qualified dividends fall under the same broad umbrella as ordinary dividends, but they are taxed differently than ordinary or non-qualified dividends. Depending on your income level and tax-filing statues, the IRS taxes qualified dividends at either 0%, 15%, or 20%, just like net capital gains. Each payer of at least $10 will provide you with a Form 1099-DIV. 

On Form 1099 -DIV, you'll find the qualified dividend amount in box 1b. In order to receive the lower long-term capital gains tax rate, dividends must be paid by a US corporation or by a qualified foreign corporation. Investors also must meet the minimum holding period, which is for 60 of the 121 days beginning 60 days before the ex-dividend date.

Qualified dividend tax rates for 2022

 Source: IRS

In general, if you buy and hold dividend stocks long-term, you'll pay the lower qualified dividend tax rate.

Important: Payments on some investments like real estate investment trusts (REITs) and master limited partnerships (MLPs), are not qualified dividends. Others not subject to qualified dividend tax rates are special dividends, dividends from money market accounts , or shares that were hedged as in a short sale.

Meeting the requirements for qualified dividends can pay off since the maximum possible tax rate would be 20% instead of 37%. The higher tax rates on ordinary dividends are for those individual tax filers earning more than $445,850 and couples filing jointly with income over $501,600. 

A benefit of holding your qualified dividend investments within a traditional retirement account is that you can defer taxation until withdrawal. However, an important caveat is that within your traditional IRA or 401(k), your dividends will be taxed at the ordinary tax rate, even for qualified dividends. 

Mullaney notes that the majority of Americans keep the bulk of their financial wealth in traditional retirement accounts, thus losing the lower tax rate benefit for qualified dividends. However, while acknowledging that the concern is "legitimate," he says it's "not a sufficient reason to avoid investing in securities paying qualified dividends inside a traditional retirement account."

Qualified dividend example

Although qualified dividends increase your overall income, they are accounted for separately from ordinary income and at different tax rates. To get the preferred rate of 0% on qualified dividends, as a single filer, your taxable income needs to be $41,675 or less. For a married couple filing jointly, the threshold is $83,350. 

Take for example a married couple filing jointly and earning a combined $75,000 (taxable) annually. They would pay the marginal tax rate of 12% on all income between $20,551 and $83,550. However, they would owe nothing on a $2,000 qualified dividend payment because their income still falls under that income threshold. (If these were ordinary dividends, the 12% rate would apply on dividends above the 10% income total.)

The bottom line

Essentially, for all tax brackets, the tax bill on qualified dividends is lower than on ordinary dividends, making it worth some effort to shift to qualified dividends when possible. Qualified dividends could result in as little as $0 owed in taxes on that income for some earners. 

Both ordinary dividends and qualified dividends, however, offer investors increased cash flow and can be a hedge against inflation. Although the lower tax bill on qualified dividends is preferable, ordinary dividends also provide that cushion of cash flow during the years before you sell shares of stock.