How Different Dividends Are Treated Under The U.S. Tax System

As much as I hate to say it, yet another tax day is rapidly approaching. Like me, you’re probably busy wrestling with all the forms and trying to figure out all the convoluted rules and regulations.

That’s why I’ve decided to devote today’s story to the subject of dividend taxation. I can’t say it’s the most exciting topic I can think of, but it is something you should understand … even if you’ve already filed your taxes or use the services of a professional.

Reason: Understanding how different dividends are treated under the U.S. tax system can help you differentiate between good investments and bad. And it can help you figure out why some yields might look artificially high (or low).

Let’s Start with the Basic Common Stock Dividend

Most investors buy common stocks. And when it comes to dividends from those issues, I have good news:

As part of the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax rate on most stock dividend payments was lowered. And for most people, the tax rate on qualified dividends is now 15 percent. An extension, signed in May 2006, guarantees this rate through 2010.

When you look on your 1040 form, you will see a box on line 9b for “qualified” dividends. This is where you enter dividend amounts that are covered under the special treatment. And when you receive 1099 statements from your broker, they should specifically note what dividends count as qualified distributions.

From there, you will probably have to use the IRS’s supplied worksheet to figure out exactly how much tax is owed on those dividends. But generally speaking, you will pay a much lower rate than you would on many other investment gains.

Note, however, that you must have held the stock for more than 60 of the 121 days surrounding the “ex-dividend” date. Many investors fail to note this rule.

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.

Okay, So What Stock Dividends Aren’t Qualified Distributions?

There are a couple of common dividend-paying investments that do not get this favorable tax treatment. Here are three of them:

Real Estate Investment Trusts (REITs): REIT dividends are treated as ordinary income 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 so much higher than other investments, and also why Uncle Sam wants as much of those dividend payments as possible. And given the poor recent performance of many REITs, that’s additional salt in the wound.

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 ol’ 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!

What happens is that the cost basis of your partnership units - the price you originally paid - gets adjusted up and down for distributions, income, and those passed-through tax items. If you’re a Dividend Superstars subscriber, take a look at issue #5 in the online archives for a complete step-by-step example of how this works.

Trust Preferred Shares: A lot of investors are becoming attracted to this special class of stock, especially because yields have gone sky-high in the midst of the financial crisis. But as I just told my Dividend Superstars subscribers in the March issue, not all preferred shares are treated equally come tax time.

Only some qualify for the 15 percent 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. So in addition to some of the other risks surrounding these shares, there is also the prospect of having your dividends taxed at a higher rate.

Reinvesting Your Dividends? Save Your Records!

Let me reiterate my love of dividend reinvesting. Whether you do it through an actual DRIP or through your broker, I think buying additional shares of stock with your dividend payments makes a lot of sense. (Unless you need the income to live on right now, of course.)

However, there is a bit of a wrinkle when it comes time to sell shares of your dividend-reinvested stock …

Figuring out your taxes can be a pain, but keeping good records makes it a lot easier!

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 have to 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.

You might also be wondering when your holding period for the new shares begins. If you receive the shares instead of a cash dividend, it’s the day after the dividend date. It you buy optional shares through a DRIP plan, it’s the day after the plan makes the purchase for you.

If you want to harness the powerful compounding that comes from dividend reinvestment - and avoid the record keeping issues - you should try to hold these stocks in tax-sheltered accounts such as Roth IRAs.

One last thing: While paying commissions typically lowers your stock’s cost basis, that is not necessarily true in the case of dividend reinvestment. For example, if the company pays the commission or provides a discount on purchases, those are treated as additional dividends. And if your DRIP charges you a service fee, that is considered an investment expense - i.e. it is deductible on Schedule A but doesn’t lower your cost basis in the shares.

Lastly, a Few Words About Mutual Fund Dividends

If you invest in mutual funds, you probably see all sorts of “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 old 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.

Obviously, I’ve just skimmed the surface today. But this information should cover most of your investments. If you have additional questions, or a more complicated situation, I strongly suggest enlisting the help of a professional tax preparer. More often than not, you will end up saving more in taxes and time than the amount your accountant charges!

To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive.

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