I hate to remind you, but Tax Day is now just about one month away … and unless you’re one of those really prepared people, it’s likely that you’re still gathering together your papers or desperately trying to schedule an appointment with an accountant.
So today I want to talk a little bit about some of the tax issues related to one of my main areas of expertise — dividend payments.
Now, I should remind you that I’m not an accountant or a tax expert … and the following information is no substitute for professional guidance to suit your personal circumstances. However, I can give you some general guidelines that I think will be helpful.
Let’s Start with Some Good News …
Because of the 2010 Tax Relief Act, qualified dividend payments will continue to receive favorable tax treatment all the way through 2012.
Now, what does “qualified dividends” mean? Well, a simple way to explain it is that most of the dividends you receive from common stock fall under this category.
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. For most investors, the rate amounts to 15 percent … which is typically much 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. 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.
Of Course, There Are Some Other Special Categories of
Dividends as Far as Uncle Sam Is Concerned …
Some common dividend-paying investments do NOT get favorable treatment on Tax Day. 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 an Income 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: Only some preferred stock dividends 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.
You Also Have to Watch Mutual Fund Dividend Payments!
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.
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 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.
And 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.
What 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.
Of course, if all of this stuff is making your head spin there’s one way to avoid most of the madness — do your investing inside a tax shelter. I’ll profile some of your best options in one of my next articles.
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