Okay, I promise this is the last column I’m going to write about taxes for a long time. Really!
It’s not like I enjoy talking about them all that much, mind you.
It’s just that we are right down to the filing deadline and I DO think that being smart about your taxes is one of the surest ways to not only keep your wealth intact but also to keep it growing efficiently.
So today I want to key off what I said last week about Master Limited Partnerships and do a quick rundown on the rest of the big tax issues related to dividends and other income investments, starting with another unique type of vehicle — Real Estate Investment Trusts (REITs).
Like MLPs, Real Estate Investment Trusts get special tax treatment at the corporate level. That allows them — requires them, actually — to pass along most of their earnings to shareholders in the form of dividend checks. And despite the massive real estate implosion … a lot of these companies HAVE continued paying out solid income.
The bad news is that — unlike the income from MLPs — REIT dividends do not carry any special tax advantage. In fact, they are actually taxed more heavily than most dividends because they are treated as ordinary income.
Remember, Most Dividend Income Received from Common Stocks
Continues to Get Treated Very Favorably in 2010 and Beyond!
For most people, dividends from plain ol’ corporations are still taxed at just 15 percent.
Originally, this favorable rate was set to expire in 2010. But because of the latest tax package it will remain in effect through 2011, too.
That’s terrific news, and is yet another strong argument in favor of buying and holding solid dividend payers (as I’ve been advocating for years!).
So how do you take advantage of this special rate?
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.
One hitch is 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.
It’s also worth noting that other categories of income investments are excluded from the favorable rate.
Take preferred shares, for example.
This special type of stock blurs the line between a bond and a stock. But 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.
What 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! That’s because many institutions use the term to denote even regular interest payments.
But the same basic rules I’ve just outlined will also 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.
And Now One Last Word of Warning for Anyone Reinvesting Dividends …
It’s no secret that I love the idea of reinvesting dividends. I think it’s a great way to rapidly build your wealth and increase your future income streams.
However, I do feel compelled to note that it can create a major headache come tax time.
Reason: When you sell your shares, the IRS expects you to figure the actual price you paid for each lot of stock. It’s not enough to come up with an average price!
What this means is that it’s critical to keep good records — especially if you’re going to employ a dividend reinvestment plan over many years. Having that paper trail will make determining your cost basis much easier.
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.
Also, 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.
Of course, perhaps the smartest thing you can do is simply use some of the tax-sheltered accounts I’ve discussed here before — things like IRAs, 401(k)s, or education savings accounts.
Doing so will — in nearly all cases other than with MLPs — minimize the amount of tax homework you have to do PLUS allow your nest egg to grow even more quickly. And it will often lower your current tax burden to boot!
Best wishes,
Nilus
P.S. If you want to know what specific dividend plays I’m recommending right now, just click here to watch my latest video presentation.
{ 8 comments }
Use a tax-sheltered account such as an IRA or 401(k)? NO! Not unless it’s a Roth IRA or Roth 401(k). Unless it’s a Roth IRA or Roth 401(k), all that does is to convert qualified dividends that would be taxed at the 15% rate into ordinary income likely to be taxed at a much higher rate, admittedly usually many years in the future.
All my retirement is in an IRA right now except my checking account..it makes it much simpler at tax time. Some low income seniors won’t have to pay any income tax on the funds withdrawn from their IRA if the rest of their income is low. I’ve made sure mine is.
Joe-
I don’t fully comprehend what you have done with your finances so I cannot comment on it. You are certainly correct that some low income seniors will not have to pay any income tax on their non-Roth IRA and 401(k) withdrawals provided that their total income (including non-Roth IRA and 401(k) withdrawals), not just “the rest of their income” is low. (Roth withdrawals are, of course, tax-free provided that certain requirements are met.) But why would anyone want to insure that his or her income is low? Isn’t it better to have a higher income even though it requires the payment of income taxes? One’s financial goal should be to maximize income after income taxes, not to minimize income taxes.
I stumbled into putting a couple of MLP’s in my IRA account. Now I receive 1099’s with my name and the account number as the Tax ID. What the heck am I supposed to do with these things when I prepare my taxes?
Thanks so much
My understanding is to put dividends in Roth Ira’s and MLP’s in non-Roth IRA’s.
Re MLP’s………Is it MANDATORY that a K-1 form be used to figure taxes. I’m 78 and not interested in tax deferment. I want income even though I assume that my MLP’s will be taxed as ordinary income. Are there other complications at sale time if this can be done?
What is the difference between a MLP and a LLC?
MLP’s continued…
… I thought that all income (dividends, capital gains, whatever) that you received from a security in either IRA categories would be accumulated tax free.
On a traditional IRA you will have to pay taxes on all IRA withdrawals in year taken.
On a Roth IRA you can make withdrawals tax free.
Receiving a 1099 that indicates any tax obligation on earnings in the IRA seems to negate the advantage of the account.
And I don’t see how to gain any advantage on reducing the cost basis; because in an IRA you are never going to make a capital gains calculations.
Oh, it makes my brain hurt.