When you invest in funds, such as mutual funds or exchange-traded funds (ETFs), one of the income sources you’re likely counting on is dividends. As a reminder, dividends are your portion of a fund’s profits that they’re sharing with you, because you own a part of the fund through your shares. It’s important to know that not all dividends are treated equally. The type of dividend you receive can determine how it’s taxed and ultimately how much money stays in your pocket. With that said, only dividends in taxable accounts need to be scrutinized. In tax-advantaged accounts like IRAs or 401(k)s, earnings and dividends grow tax-free regardless of the dividend type. Therefore, the type of dividends you receive is only particularly important to consider and review for non-qualified accounts such as individual and joint brokerage accounts.
In your taxable accounts, fund dividends generally fall into two categories: ordinary dividends and qualified dividends. Both are payouts you receive from the fund’s earnings, but they’re taxed differently. Ordinary dividends are considered taxable income by the IRS, and they’re taxed at your ordinary income tax rate. For instance, if you’re in the 24% tax bracket, your ordinary dividends will be taxed at 24%. On the other hand, qualified dividends enjoy a more favorable tax treatment. They’re taxed at the long-term capital gains tax rates, which are typically lower than ordinary income tax rates. Depending on your taxable income, the tax rate on qualified dividends generally is 0%, 15%, or 20%.
The key difference, then, is the tax rate. With qualified dividends, you get to keep more of your earnings after taxes, but how can you know which type of dividend you’ll receive? The type of dividend and tax treatment you receive depends on several factors including how long you or the fund’s manager have held the position, the type of securities in the fund, and the fund management style (i.e., active vs passive).
You or the fund manager must hold the fund or positions in the fund for more than 60 days during the 121-day period that begins 60 days before the fund’s ex-dividend date. The ex-dividend date is the date set by a company’s board of directors after which any new buyers of the company’s stock (or in the case of a fund, any new buyers of the fund’s shares) will not receive the upcoming dividend payment. The holding period requirement is also true for investment managers that are trading the securities that make up the fund.
Funds that invest in U.S. corporations and certain qualified foreign corporations are more likely to pay qualified dividends. The IRS has specific requirements for which foreign corporations’ dividends can be classified as qualified. Conversely, dividends from certain types of investments, like REITs (Real Estate Investment Trusts) or money market instruments, are generally not eligible for qualified dividend treatment.
Generally, actively managed funds tend to provide less qualified dividends. In actively managed funds, investment managers make decisions about which securities to buy or sell, and when to do so, based on their research and judgment. These decisions can directly affect the tax treatment of the dividends you receive as a shareholder, because the more trading within the fund, the greater the chance is that the holding period requirement is not met.
No matter the type of dividend you receive, the custodian where the fund is held should send you a Form 1099-DIV each year. This form provides the information you need to determine how your dividends will be taxed.