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This answer does not explicitly address the question of whether non-qualified or qualify dividends get taxed first, but am I correct that non-qualified dividends get taxed before qualified dividends do?

For example, suppose that in 2024 you're filing as single and you make $40,000 in taxable wages, $7,150 in non-qualified dividends, and $7,150 in qualified dividends.

A. If the non-qualified dividends get taxed first (which I believe is the case), then:

  1. You'd pay the 12% marginal ordinary income tax rate on the non-qualified dividends, so 12% * $7,150 = $858, and
  2. You'd pay the 15% marginal long-term capital gains tax rate on the qualified dividends, so 15% * $7,150 = $1,072.50, for a total tax of $858 + $1,072.50 = $1,930.50 on your dividends.

B. If qualified dividends get taxed first, then

  1. You'd pay no capital gains taxes on the first $7,025 of the qualified dividends, because they take you up to the top of the 0% marginal long-term capital gains tax,
  2. You'd pay the marginal long-term capital gains tax rate of 15% on the next $125 of qualified dividends, so 15% * $125 = $18.75, and
  3. You'd pay the 22% ordinary income marginal tax rate on the non-qualified dividends, so 22% * $7,150 = $1,573, for a total tax of $18.75 + $1,573 = $1,591.75 on your dividends.

(Note that the fact that non-qualified dividends get taxed first does not necessarily always raise your tax bill for your dividends. For example, if you made $90,000 in taxable wages, $10,525 in non-qualified dividends, and $10,525 in qualified dividends, then if the non-qualified dividends get taxed first you'd pay $2315.50 + $1578.75 = $3894.25 on your dividends, but if the qualified dividends were taxed first then you'd pay $1578.75 + $2,526 = $4,104.75 on your dividends.)

tparker
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2 Answers2

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You think that the capital gains marginal brackets and ordinary income marginal brackets are not related to each other. It's a common misconception.

You also seem to think that qualified dividends are treated as capital gains, which is also another common misconception.

Take a look at the IRS Tax Topic 409, which discusses capital gains:

A capital gains rate of 0% applies if your taxable income is less than or equal to:

$44,625 for single and married filing separately;

Notice the highlighted part: it says your taxable income. I.e.: your total taxable income, not just capital gains. So the capital gains tax brackets depend on your total taxable income, all included. The order in which you sum it all up doesn't matter.

Qualified dividends are called that way because they're dividends (not capital gains!) that qualify for preferential tax treatment, and taxed at the same rate as capital gains.

For the practical demonstration of how this work follow the steps of the capital gains tax calculation worksheet for the form 1040:

  1. Calculate total taxable income (form 1040 line 10 in the example above, since it's for 2018)
  2. Calculate all income subject to capital gains rates (which is long term capital gains with some exceptions and qualified dividends)
  3. Iterate through capital gains brackets based on the amount calculated in step 1 until the amount calculated in step 2 is depleted, adding up the tax per bracket.
  4. In the end (on form 1040, after completing the worksheet), recalculate the total tax based on the regular marginal rates excluding the amounts calculated in step 2 from the amounts calculated in step 1, and add the tax calculated in step 3 to the result. That's your total tax.

If I understand your question correctly, what you're trying to formulate is step 4. The marginal rates for ordinary income are determined first, in a sense you're trying to describe, but you go through the marginal rates for capital gains for capital gains regardless and capital gains can't push you into a higher ordinary rates bracket.

littleadv
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TLDR: Your option A is correct in result.

The US income tax is nominally defined in IRC section 1 as a series of mathematical computations -- so many % of certain amounts of income -- and this is how it is described in most IRS publications and practically all comments and analysis by others. In particular it is used by the IRS resources used within a tax year to estimate or predict tax -- Form 1040-ES and instructions and Publications 505 and 15-T (formerly 15 and 51), plus Form 1040-C and instructions which is a 'rough draft' tax return required for some departing aliens.

Using (few) needed bits from form 1040 that don't vary from year to year and the computation specified by 2024 pub 505 worksheet 2-5 but putting the amounts at the left instead of the right (so it's MUCH easier to line them up):

54600 wages (40000 + standard deduction 14600 for nondependent single nonelderly/disabled)
14300 dividends (7150 qualified, 7150 unqualified)
68900 gross income and AGI (no QBI, no schedule 1 part 2 e.g. IRA, HSA, student loan interest ...)
14600 standard deduction 
54300 taxable income (line 1)
 7150 preferred-rate income (lines 2,4,9)
47150 non-preferred-rate income (line 10)
47025 preferred-0% end (line 11) (note not same as ordinary-12% end) 
47025 preferred-0% skipped by ordinary (line 12)
    0 preferred income in 0% bracket (line 15)
47150 lines 13a,13c,14 
 7150 lower of preferred or total (line 16) less line 15 (line 18)
 7150 preferred-15% limit (line 20 discarding line 19 less line 14 and 15 giving line 22)
 7150 preferred-15% amount (line 23)

The only applicable preferred-rate tax is 15% of line 23 = 1072.50 (line 24)
The ordinary-rate tax for 47150 on line 14 is NOMINALLY 10% of the first 11600 then 12% of the rest = 5426.00 (line 37) 
Total is 6498.50 (line 38) (although most people use the dollar-rounding option making this 6499)
(If the ordinary-rate schedule applied to line 1 combined income were less it would be substituted, but it isn't.)


If no dividends (either kind) were present, ordinary-rate tax on 54600 wages 
minus 14600 standard deduction = 40000 taxable income would be 4568.


So the delta tax for the dividends (before rounding) is 1930.50 or 858+1072.50

ADDED: but when you go to actually file a return on 1040 (now including 1040-SR, formerly including 1040-A and 1040-EZ, or the 'effectively connected' part of 1040-NR) as Gomer Pyle used to say "surprise! surprise! surprise!" you don't actually use the computations from section 1. IRC section 3 states that for taxable income up to a limit "In lieu of the tax imposed by section 1" you pay "a tax determined under tables ... prescribed by the Secretary ... on the basis of the rates prescribed by section 1" (emphasis added).

Concretely, for taxable income subject to ordinary rates i.e. 1(a)-(e)+(f) then 1(i) now 1(j)(2)+(3) up to $100k the tables published in the 1040 instructions: (1) divide the income into intervals of mostly $50, (2) compute the tax according to section 1 on the midpoint of each interval, (3) round that computed tax to a whole dollar (whether or not you round other amounts under IRC 6102), and (4) use that result as tax for any income in the interval. As a result your actual tax may be a few dollars less or more than the amount stated by section 1. But such tables are NOT used for preferred-rate income up to $100k even though that is part of "the tax imposed by section 1" on such income; preferred-rate tax uses the section 1 computations always.

I'm sure this method (precomputed tables) was adopted long ago, when nearly all tax returns were prepared by hand and many by people with limited education who were likely to make errors in complicated computations. Nowadays practically all returns are prepared on computers (even if still paper-filed for various reasons) and this is a relic. But since the tables are only in the 1040 instructions published when filing season begins -- usually Jan. of following year -- they cannot be used by the in-year products.

For the specific case you asked and I showed above -- assuming they don't suddenly change this year the practice they've used for the tables for my adult lifetime -- the tax computation with dividends changes to 5423+1072.50 and without to 4565, so the delta remains 858+1072.50=1930.50 even though either actual tax is slightly different.

Also compare (my) In what order are Short Term Capital Losses applied when dealing with Municipal Bond Interest, Qualified Dividends, and Ordinary Income? which almost addresses this.

dave_thompson_085
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