Not All Dividends Are Created Equal

One of the best things about dividend investing is that you get paid simply for owning investments. Pretty nice deal.

But eventually you’ll hear terms like:

• Qualified dividends
• Ordinary dividends
• Distributions
• Capital gains distributions

And you’ll probably wonder: “What the heck is the difference?” The good news? You don’t need to become a tax expert to understand the basics.

Why different dividend types exist

Not all investment income is treated the same by the IRS. Some dividends get favorable tax treatment and some don’t. Some aren’t technically dividends at all.

That’s why you may notice different types of income showing up on your tax forms each year. The money spends the same, but the tax treatment can be different.

Qualified dividends

These are generally the most tax-friendly dividends. Most dividends paid by large U.S. companies fall into this category.

The IRS rewards investors by taxing qualified dividends at lower rates than other types of dividends. That’s good news for investors because it means you may keep more of what you earn.

Ordinary (or non-qualified) dividends

These dividends don’t qualify for the special tax treatment above. Instead, they’re taxed at your normal income tax rate (like your paycheck or interest income from a bank account). You’ll often see these from certain REITs and other specialized investments.

Does that make them bad investments? Not at all! It just means you should understand the after-tax picture.

Distributions

Some investments pay what’s called a “distribution” instead of a dividend. These often come from things like partnerships, energy (oil & gas) investments, and certain other funds.

The income can still be valuable, but the tax paperwork sometimes gets a little more complicated. You may find yourself spending more quality time with your tax software.

Capital gains distributions

First, let’s define a capital gain. It happens when an investment is sold for more than it was originally purchased for. For example, if you buy a stock for $100 and later sell it for $125, you’ve made a $25 capital gain.

Some ETFs and mutual funds buy and sell investments inside the fund throughout the year. When they do, they may pass some of those gains along to investors in the form of a capital gains distribution.

Think of it as the fund sharing some of its profits with you.

Just like dividends, that money can show up in your account even if you didn’t personally sell anything. The main difference is how the IRS classifies and taxes it.

Why it matters

Dividend income can be a powerful tool for successful investing. Some investors spend it, others choose to reinvest it and buy more shares.

Either way, the important thing is creating an investment mix that works for your goals.

The exact type of dividend matters… but probably not as much as you think. Consistent income is usually more important than the label attached to it.