As tax season approaches and before the IRS lay claim to all of your hard-earned money you might wonder: are ETF dividends qualified? I had the same question when filing my taxed last year and reporting my dividend income from some of the ETFs I have invested in. So I scoured the internet for answers.
Are ETF Dividends Qualified? ETF dividends are qualified if the ETF has been held for more than 60 days before the ex-dividend date. This means that any dividends you receive from ETFs you have invested in more than 60 days ago are considered “qualified dividends”. Any other dividends you receive from ETFs you have held for less than 60 days will be considered “non-qualified” or “ordinary dividends”.
What is the difference between a qualified and non-qualified dividend?
But why should you even care if dividends are qualified or not? Well, as so often the answer has to do with the tax rate you are going to pay on your dividend earnings:
|Qualified Dividends||Non-Qualified Dividends|
|Tax Rate||0 to 23.8%||As ordinary income|
The higher your ordinary income, the more beneficial it will be to have your ETF dividends taxed as qualified dividends and paying only 5%, 10% or 20% – depending on your tax bracket – instead of your ordinary income tax rate.
In terms of taxation this is the only difference between qualified and non-qualified dividends. However, there are few more requirements for a dividend to be even eligible for the qualified status.
As stated in the United States Internal Revenue Code qualified dividends are basically ordinary dividends that simply meet additional criteria to be taxed at a lower long-term capital gains tax rate. This rule was added rather recently during the Bush tax cuts of 2003 to encourage to encourage longer-term investing by reducing the tax burden for investors.
In order for the dividend to be taxed at the qualified rate the dividend has to:
- be paid after December 31, 2002
- be paid by a U.S. corporation, by a corporation incorporated in a U.S. possession, by a foreign corporation located in a country that is eligible for benefits under a U.S. tax treaty that meets certain criteria, or on a foreign corporation’s stock that can be readily traded on an established U.S. stock market (e.g., an American Depositary Receipt or ADR), and
- meet holding period requirements: this is basically the same requirement of holding an ETF for more than 60 I mentioned earlier. I also want to point out that the number of days of ownership includes the day of disposition but not the day of acquisition.
Are Bond ETF Dividends Qualified?
If you have invested in any bond ETFs such as Vanguard’s BND and received your quarterly distribution you might wonder like me whether those bond ETF dividends are qualified as well.
The answer basically depends on the same requirements as laid out above. So need to examine if the bond ETF owns stock that pays a qualified dividend according to the payment date (after 2002), the U.S. domestic requirement (U.S. corporation or similar entity) and the holding period.
However, there is an important difference between “stock ETFs” and “bond ETFs”. While stock ETFs hold a multitude of stock from different companies, aggregate their dividends and they out the aggregate sum to investors, bond ETFs own bonds of all the the companies in their fund, aggregate interest and pay out the aggregated interest as dividends to investors.
This means that bond ETF dividends you may receive can never be taxed as qualified dividends since the underlying payouts the ETF receives are actually interest payment not dividends. This is the case for treasury, municipal, foreign, short-, mid- or long term bond ETFs.
Which ETFs pay qualified dividends?
Now that we have looked at what the basic difference between qualified and ordinary dividends is and how you can take advantage of a lower tax rate I wanted to take a moment to go through the ETFs you can invest in that actually pay qualified dividends.
The following ETFs meet all the requirements:
just to name a few.
Remember that even though these ETFs meet the base requirements of owning only U.S. stock so still need to fulfill the holding period requirement of at least 60 days before the ex-dividend date.
Oftentimes you may want to further diversify your portfolio by adding some index funds with international exposure such as VSUX or VYMI. In this case you need to do additional research before declaring any dividends you receive from such funds as qualified.
Most of those international ETFs will hold a significant portion of stock from non-U.S. companies. This fact alone will disqualify any dividend payment you receive from being considered qualified and taxed at lower rates. One of the reasons this domestic requirement has been added to the tax cuts in 2003 was to encourage long-term as well as domestic investments.
Are dividends taxed twice?
While I was researching whether ETF dividends are qualified I came across I few interesting points about dividend taxation in general.
Dividends are taxed twice in the sense that the company paying out the dividends to shareholders will pay corporate income tax on dividends as they are considered profit and thus – not deductible. The second taxation occurs when investors declare the dividend payments they received and pay personal income taxes either at the qualified or ordinary rate.
This phenomenon is sometimes called the double-taxation of dividends:
- Corporate income tax paid by dividend distributing corporation
- Personal income tax paid by investors receiving such dividend payment
How do I avoid paying tax on dividends?
As we have seen there is a significant difference between dividends being taxed as ordinary income or as long-term capital gains. To illustrate this point let’s have a look at the following table for 2020:
|Income||Ordinary Income||Long-Term Capital Gains|
|$0 to $9,875||10%||0%|
|$9,876 to $40,125||12%||0%|
|$40,126 to $85,525||22%||15%|
|$85,526 to $163,300||24%||15%|
|$163,301 to $207,350||32%||15%|
|$207,351 to $518,400||35%||15%|
|$518,401 or more||37%||20% (over $441,550)|
No matter which tax brackets you are in it will always be advantageous if you can declare your dividend payouts as qualified.
You may ask yourself if there isn’t a way to – legally – avoid paying tax on dividends all together.
Well, unless your total income is below $40,000 there really is no way to pay absolutely no tax on your dividend earning unless you want the IRS coming after you. But there are a few things you can do hopefully minimize your tax burden. Here some of the things I have done:
- Shift your income to less tax heavy income streams such as rent payments or real estate appreciation.
- Contribute as much as possible to your 401k to maximize your adjustments and deductions.
- When choosing your primary residence make sure to pick a state with a lower state tax.
- Learn about taxation: educate yourself on tax rules you can take advantage of (reading this post is a good start ;)).
Most ETF dividends you receive will be considered qualified if you have held the fund for a more than 60 days. This will allow you to pay the long-term capital gains tax rate on those dividend earnings instead of the ordinary income tax rate.
Personally, I aim to have all my dividend payment classified as qualified by investing for the long term and thus holding my ETFs over multiple decades, ideally never selling. I don’t speculate on price and don’t even care if the market goes up or down. All I want is my quarterly payment of qualified dividends!
How long are you holding your ETFs? Have you made use of the long-term capital gains rate yet?