Both types of dividends may be subject to the net investment income tax
While qualified dividends are taxed at lower rates than ordinary dividends, it's important to point out that higher earners pay an investment income tax that's the same for all dividend income.
Specifically, the net investment income tax (NIIT) is a 3.8% tax rate applied to certain dividend income, interest income, capital gains, and other investment-derived income. If you're a single tax filer and have adjusted gross income (AGI) of more than $200,000 or file a joint return with AGI over $250,000, you have to pay the tax on any investment income that pushes your income over these limits.
Without getting too deep into a discussion of the NIIT, the point is that if it applies to you, the rate is the same whether your dividends are qualified or not.
An example of how qualified dividends save you money
Here's a simplified example of how this works. Let's say you're single and have taxable income of $100,000 in 2019 from your job. You also earn $3,000 in dividend income for the year. Based on your income, you would pay a 15% tax rate on qualified dividends or a 24% tax rate on ordinary dividends.
If your $3,000 in dividend income meets the criteria for qualified dividends, it would add $450 to your tax bill for the year. If it doesn't, it would add $720. In this case, the favorable treatment given to qualified dividends would save you $270 over your ordinary income tax rate.
REIT dividends can be a combination
Some dividends -- specifically those paid by real estate investment trusts, or REITs -- aren't just one type or the other.
In fact, REIT dividends are often made of three components. Most REIT distributions are ordinary dividends, but some might be qualified dividends or a non-taxable return of capital.
For example, leading net-lease REIT Realty Income (NYSE: O) paid $2.63 per share in common stock dividends in 2018. Of this, about 77% was ordinary income and the other 23% was a non-taxable return of capital. While the percentages can vary, this is a pretty typical distribution -- most REIT dividends are typically ordinary income, with a return of capital being the second-largest type of distribution in most cases.
In some cases, a small portion of a REIT's dividend might be a qualified dividend -- this happens if a REIT sold an asset at a profit and distributes some of its long-term capital gains to investors.
Like I mentioned earlier, you won't have to figure this out on your own. Each REIT issues tax guidance shortly after the end of the year. Your dividends should be broken down by category when your broker sends your annual tax paperwork.
These rules only apply to taxable accounts
The qualified dividend definition is only important if your dividends were paid in a taxable brokerage account.
If you own the stocks through an individual retirement account, or IRA, you won't have to pay any tax on dividend income you receive, regardless of whether the dividends are qualified or not. With a traditional (pre-tax) IRA, you won't owe any tax until you withdraw the money from the account. Even then, all of the money you withdraw will be treated equally as ordinary income. And with a Roth IRA, withdrawals that meet the IRS's requirements will be completely tax-free.
If all of this sounds very complicated, don't worry. It's good to know, but there's little chance that you'll have to figure it out yourself. Your broker or REIT will let you know whether your dividends are qualified.