I’ve been pushing off my tax-filing duties this year. That means I’m now knee-deep in forms for three different states and the usual assortment of federal paperwork and schedules.
Isn’t early April great?
So, in keeping with the theme, today I want to talk about the taxation of dividend payments.
Obviously, there’s no way I can cover the entire subject in one short article. And this column is no substitute for professional advice from a tax professional who understands your particular situation.
But Let’s Start with Common Dividends:
The Type You Receive from Most Stocks
Through 2012, "qualified dividends" — the ones you typically get from owning regular common stocks — were taxed at very favorable rates for everyone. And that continues to be true for MOST people filing their 2016 tax returns.
If you’re in one of the bottom two tax brackets, you won’t owe any taxes on qualified dividends at all. Most people in higher brackets owe 15%.
The exception? Anyone making more than $415,050 a year or $466,950 if married.
Folks in that range will pay an extra five percentage points more. That takes them all the way up to a 20% tax rate on qualified dividends.
When you look on your 1040 form you will see a box on line 9b where you enter your qualified dividends. Also, 1099 statements from your broker should specifically note what dividends count as qualified distributions.
From there, you might have to use the IRS’s supplied worksheet to figure out exactly how much tax is owed on those dividends.
Again, for most investors it’ll still be 15%, which is probably lower than your ordinary income rate.
Note, however, that you must have held the stock for more than 60 of the 121 days surrounding the "ex-dividend" date.
In addition, you cannot treat qualified dividend payments as "investment income" for investment interest expense deductions. You can forgo the special tax rate and then use them to offset the interest expense.
And if you do your investing in a tax-sheltered account like a traditional IRA or 401(k) plan, there’s some good news. That’s because your dividends are not subject to income taxes right now. However, they will probably be treated as ordinary income when you do start making withdrawals.
Meanwhile, Many Special Types of Dividend
Payments are Treated Differently …
Some common dividend-paying investments do NOT get favorable treatment.
Real Estate Investment Trusts (REITs): REIT dividends are treated as ordinary income. That’s because these companies generally do not pay taxes at the corporate level. Instead, they dole out most of their income to their investors in the form of dividends.
This is why their yields are often higher than other investments. It’s also why Uncle Sam wants as much of those dividend payments as possible.
Master Limited Partnerships (MLPs): An MLP’s income is treated as if it is earned by "the partners" (i.e., shareholders) and is allocated to them based on their individual stake. The partners also share in any other events that typically affect taxable income, such as deductions and credits.
By all appearances, these payments look like plain dividends.
However, there’s an important difference at tax time. The bulk of the quarterly distributions are considered a return of capital … and not taxable investment income.
Translation: Most of your distributions are tax-deferred!
At the same time, parts of your payments can be considered unearned business income. Which is why MLPs are typically best held outside tax shelters like IRA accounts.
Trust Preferred Shares: Only some preferred stock dividends qualify for the 15% dividend tax rate. These are known as "traditional preferred" stocks.
In contrast, any income from "trust preferred" shares will be taxed at your ordinary income rate. That is because they are technically considered debt securities.
Mutual Fund Dividend Payments
Are Also a Separate Animal Entirely …
If you invest in mutual funds, you probably see various "dividend" payments. Even when your fund doesn’t invest in dividend stocks!
Many institutions use the term to denote all kinds of payments, including regular interest.
But the same basic rules apply to your mutual fund holdings …
Dividends from common stocks will usually get taxed at the qualified rate,
Most other dividends will be treated as ordinary income, and
Long-term capital gains will be treated as such.
The tax statements sent from your fund company or brokerage should break the categories up for you.
Last But Not Least,
If You Reinvest Your Dividends …
I applaud you for using a terrific wealth-building strategy!
However, Uncle Sam isn’t going to give you the same pat on the back. It’ll be more like a pat down.
Reason: The IRS doesn’t allow you to just figure out an average cost basis for all the shares you’ve bought over time. Instead, you must determine the actual price paid for each purchase.
This makes saving your account statements VERY important!
Having that paper trail will make determining your cost basis much easier. And the longer you practice dividend reinvestment, the more complicated things will become without adequate records.