Dividends represent the profit a company pays to its shareholders; stocks and mutual funds can both produce dividend income. There are two basic categories of dividends, ordinary dividends and qualified dividends, both of which are taxable. Ordinary dividends are taxed as ordinary income, while qualified dividends are usually taxed at the rate of capital gains, which are generally lower than ordinary income tax rates. Dividends can be earned on both common and preferred stock, with ordinary dividends being the most common form of corporate earnings’ distribution to shareholders. 

In order to qualify for capital gains treatment, qualified dividends must meet special requirements.  For example, this type of dividend must be from a U.S. corporation.  There are certain restrictions if a foreign corporation is issuing the stock. There are also specific holding period requirements for the stock:  the investor must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (90 days for preferred stock, see IRS Publication 550).

Qualified dividends are subject to 5 percent or 15 percent maximum tax rates depending on the individual’s income tax rate.  If the applicable income tax rate is 25 percent or more, the qualified dividends are taxed at 15 percent.  If the applicable income tax rate is less than 25 percent, the qualified dividends are taxed at 5 percent. For additional information, see the IRS site at http://www.irs.gov/taxtopics/tc404.html for information about dividends and http://www.irs.gov/newsroom/article/0,,id=106799,00.html for information about capital gains.