Taxes in Dividend Stocks

TAXES

I was hesitant to write this chapter. In fact, I didn’t even include it in the table of contents in the proposal to my publisher. What I really hate is how complicated taxes can be. It’s why this chapter wasn’t in my original plans for the book. However, taxes are an important issue that needs to be addressed.

Keep in mind that I am not a tax expert. I will cover only the basics of tax law as it pertains to dividends. If you have any questions, you should always seek the advice of a tax professional.

Here’s what you need to know:

Dividend tax rate = 15%

That’s it. Any questions?

OK, it’s a little more complex than that.

In 2012, if you are in the 25% tax bracket or higher, your dividend tax rate will be 15% on all qualified dividends.

That’s been the case since 2003, when President Bush signed the Jobs and Growth Tax Reconciliation Relief Act. In 2010, President Obama extended the tax cuts that set the dividend tax rate at 15%. It is unknown at this time if he and Congress will extend it again or if they will let it expire at the end of 2012.

If the tax cuts expire, it is expected that dividends will be taxed at the individual’s ordinary income tax rate. Of course, in politics, anything can happen and tax policy may change considerably at any time. 

But if you’re reading this just when it was published because you ran to the bookstore or ordered it online as soon as the book was available (thanks, Uncle Bob), you will pay 15% tax on your qualified dividends.

Foreign Taxes

It’s bad enough you have to pay U.S. taxes, now you’re being asked to pay taxes in other countries? Well, yes and no. But don’t worry, you’re not getting taxed twice.

Depending on the tax laws of the country where the company is based, taxes may already be taken out by the time you receive the dividend.

For example, if you are paid a dividend on shares of Telefonica (NYSE: TEF), the Spanish mobile phone company, the government of Spain will help themselves to 19% of your dividend payment.

When you calculate your U.S. taxes, you fill out IRS Form 1116, which will generate a tax credit on the amount paid to a foreign government.

Paying taxes to a foreign government is a pretty regular occurrence. If you’ve ever owned a mutual fund that owns foreign stocks, chances are you’ve paid foreign taxes and had to claim the foreign tax credit before.

Some countries don’t tax you at all, in which case, you’ll just pay the U.S. tax rate. But you’re going to pay someone. Uncle Sam, Uncle Jacques, or Uncle Pedro are going to get their money. You can be sure of that.

There also can be different rules depending on the type of account you hold your stock in. For example, if you own foreign stocks inside an Individual Retirement Account (IRA), you are not eligible for a tax credit. Additionally, your adjusted gross income may impact the amount of the credit that you are eligible for. Be sure to talk to a tax advisor with any questions.

Tax-Deferred Strategies

In Chapter 6, I mentioned Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), Business Development Corporations (BDCs), and closed-end funds, which often classify a significant portion or all of their distributions to shareholders as returns of capital.

As we discussed, a return of capital typically is not taxed in the year in which the distribution is received. Instead, it lowers the cost basis on the stock, and you will pay capital gains on the adjusted cost basis when you sell the stock.

How Return of Capital Works

Purchase stock: $10

Return of capital: $1

Adjusted cost basis: $9

Sell stock: $20

Capital gain: $11

In this example, an investor bought a stock for $10. She received a dividend of $1 per share that was all return of capital. She will most likely not pay taxes on the $1 in the year it was received. So her cost basis falls to $9 from $10. When she sells the stock, it’s trading at $20. Her capital gain is $11 instead of $10 because her cost basis was lowered by the $1 return of capital.

You can also defer your taxes based on which type of account your dividend stocks are in.

For regular dividend stocks, such as Perpetual Dividend Raisers, consider holding them in a tax-deferred account such as an IRA, 401k, or 529 plan. That way the dividends and reinvested dividends will grow tax free until you retire or tap the funds for college.

Look at the difference growing the money tax-deferred makes.

Let’s assume you have an IRA and you’re reinvesting your dividends. The portfolio starts with a 5% yield and averages 8% dividend growth and 5% annual appreciation. After ten years, an account that started with $100,000 will be worth about $285,000 if you reinvest the $98,500 in dividends that you received.

If those same stocks were in a taxable account where you’re paying 15% taxes on those reinvested dividends every year, you’d have had to shell out almost $15,000 in taxes. To do that, you’d either have to sell some shares, which would slow down the compounding machine and lower your return to a total of $262,000, or you’d have to come up with the cash.

Of course, you’ll have to pay taxes on the tax-deferred account once you tap the money in it, but you also don’t necessarily have to withdraw all of the money at once, allowing the majority of the funds to continue to grow tax deferred.

Additionally, if you are no longer working, theoretically your income will be lower so your tax rate may be as well. Remember, though, that the goal of this book is to help you generate plenty of income from your investments in retirement—enough that you’ll be in the upper tax brackets if you don’t have the right tax strategy.

If you’re collecting income from MLPs, BDCs, REITs or closed-end funds (with significant return of capital), you’re usually better off holding those stocks in your taxable account.

Since the distribution is tax deferred anyway, there is no advantage to keeping it in your tax-deferred accounts. In fact, it will be a disadvantage if it replaces another income-producing investment that will be taxed as a result of being forced to reside in a taxable account because there’s no room in the tax-deferred account. Additionally, if those tax deferred investments are placed in a tax deferred account, you may actually have to pay some penalties on the income.

If tax law does change and dividends are taxed at your ordinary income level, you should talk to your tax advisor about ways to defer taxes on those dividends. You really want those dividends to compound tax deferred over the many years. Legally protecting them from the tax man for as long as possible is going to put thousands (quite possibly tens or hundreds of thousands) more dollars in your pocket.

This chapter is just the most basic guide to taxes and dividends. Tax law has tons of variables and nuances, so once again, I urge you to talk to a tax professional if you have any questions.

SUMMARY

• The current tax rate on dividends is 15%, although that rate is set to expire at the end of 2012. As of this writing, it is anyone’s guess whether our brilliant and practical leaders in Washington will keep the rate the same or raise it.
• You often have to pay foreign taxes on dividends of foreign companies. But you get a credit on your U.S. taxes for any foreign taxes that were paid.
• Consider holding your dividend stocks in a tax-deferred account, such as an IRA or 401k.
• Do not hold MLPs or other investments where the majority of the distribution is a return of capital in a tax-deferred account. The distribution is already tax deferred.
• If you didn’t get the message yet, talk to your tax advisor with any questions.