With tax season upon us and the world of dividend investing having now matured and expanded into an ever more complex universe of business types, many income investors are understandably confused about taxes on dividends.
Especially since the U.S. tax code has grown into one of the largest and most convoluted parts of our government.
In fact, the number of pages in the federal tax code expanded from 400 in 1913 to 74,608 in 2014, according to Wolters Kluwer.
Let’s take a detailed look at all of the most important considerations you need to keep in mind when it comes to the tax effects of the various dividend investing vehicles.
In this guide to taxes on dividends, we will review the tax treatment of the most popular types of dividend stocks and funds:
- Mutual funds
- International dividend stocks/ADRs
- Dividend ETFs
- Real Estate Investment Trusts(REITs)
- Master Limited Partnerships (MLPs)
- Business Development Corporations (BDCs)
- Mortgage REITs (mREITs)
- Preferred shares
- Closed-end funds (CEFs)
C-Corps and U.S. Mutual Funds Taxes: The Benefits of Qualified Dividends
Let’s start with the simplest and most common dividend most investors are faced with, qualified dividends from C-corps such as Johnson & Johnson (JNJ), 3M (MMM), and AT&T (T). Note that most U.S. mutual fund dividends are also qualified.
Qualified dividends are taxed at the long-term capital gains tax rate, as long as you hold each stock long enough (holding period).
Currently that means a holding period of 61 days or 60 days before the ex-dividend date (the date that, as long as you hold the shares by that point, you will receive the dividend). Qualified dividends are listed on tax form 1099-DIV in box 1B.
The nice thing about qualified dividends is that they are taxed at a lower rate than one’s marginal income tax rate.
For example, for lower to middle class investors, meaning those with taxable income (gross income minus deductions) less than $37,650 for single people or $75,300 for married people, you won’t pay any taxes on your qualified dividends.
Meanwhile, anyone making more than these amounts will only pay 15%, unless you are in the top income tax bracket, which pays a 20% rate.
Even if you are in the top tax bracket (a nice problem to have), you’ll still pay 54% less than the top marginal tax rate, which is actually 39.6% plus the 3.8% ACA (Obamacare) surcharge for a top tax rate of 43.4%.
Any C-corps in tax-deferred accounts such as IRAs or 401Ks face no dividend taxes as long as you don’t withdraw any funds. However, when you do start to take money out of such accounts, things get a bit more complicated.
For example, any funds held in a Roth IRA are tax-free forever, including dividends or capital gains, as long as you don’t withdraw funds until after age 59.5 (and you’ve owned the Roth IRA for at least five years).
Any cash withdrawn from a Roth IRA before this age will face a 10% penalty on any gains you’ve made, including dividends.
However, with regular IRAs, as well as 401Ks, once you begin withdrawing the annual minimum distribution (which kicks in at age 70.5), any funds will be taxed at your top marginal tax rate, including dividends.
In other words, if you hold any qualified dividend-paying investments in a non-Roth IRA or 401K, you lose the tax efficiency of owning those holdings in a taxable account.
Taxes on Dividends Paid by REITs: Now Things Start To Get Complicated
REITs are one of the most popular kinds of dividend stock because by law they must pay out at least 90% of taxable net income to investors in order to avoid paying corporate taxes.
U.S. REIT (non-US REITs are generally taxed as qualified dividends) dividends are generally composed of two parts – unqualified dividends and return of capital, or ROC.
Unqualified dividends make up the majority of the payout and are taxed as regular income at your top marginal tax rate (except in IRAs and 401Ks before you withdraw any funds) – not the favorable rate we previously saw for qualified dividends paid by C-corps and mutual funds.
ROC is a bit more complicated. Basically, returns of capital are what the IRS considers any part of the dividend above the REIT’s earnings (EPS).
And because GAAP earnings include depreciation of property, when in reality well maintained property appreciates in value, GAAP EPS doesn’t represent the actual cash flow that actually funds the dividend paid by a REIT.
Rather, REIT dividends are paid for out of adjusted funds from operations (AFFO), which is generally calculated as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) minus maintenance capital expenditures. AFFO is essentially a measure of free cash flow for REITs.
The IRS considers any dividends above EPS to be equivalent to a return of capital (i.e. the company giving back your original investment).
ROC isn’t taxed right away. Instead, taxes (at your capital gains rate) are deferred until after you sell your shares. Here’s an example of how ROC works, provided by Investopedia:
“Jennifer decides to invest in a REIT that is currently trading at $20 per unity. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholder. However, $0.60 per unit of this dividend income comes from deprecation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($1.80 – $0.60) of this dividend comes from actual earnings.
This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by $0.60 to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a long- or short-term gain/loss when the units are sold.”
As you can see, ROC is deducted from your cost basis, and the government doesn’t get its share of the payout until you sell your shares, at which point the deferred ROC portion of the dividend is taxed as a capital gain.
If you own shares for over one year, then this means a tax rate of 0%, 15%, or 20%, based on your marginal income tax bracket.
The great thing about ROC is that taxes are deferred as long as you don’t sell your shares.
And for blue chip, high-quality, “buy-and-hold forever” REITs such as Realty Income (O) or Welltower (HCN), if you never sell, you will never pay taxes on this portion of the dividend, up to your original cost basis.
Once your cost basis hits zero, the ROC portion of your dividend is taxed as a qualified dividend.
Best of all? You can pass these shares onto your heirs, up to $5.9 million worth (for an individual) or $10.9 million for a married couple, tax free.
When you do, the cost basis will automatically reset the share price at the date of your death, meaning that all of the deferred ROC those shares have accumulated over years will become permanently tax exempt.
How exactly do you determine how much of a REIT’s dividend is unqualified dividend and how much is ROC?
Each year, REITs will send out two tax forms, a 1099-DIV and an 8937 (you can also generally find these forms online).
The 1099-DIV will tell you what portion of the payout is ordinary income and the 8937 will layout the ROC.
For example, Realty Income’s 2016 form 8937 is below and shows that 21.5% of the dividends were ROC (the last two columns on the right).
That means that only 78.5% of the dividend for that year is taxable as ordinary income, while the remainder (51.4 cents per share) should be deducted from your cost basis for tax purposes.
Only after you sell those shares will this part of the dividend be taxed, and if you never sell, then it will become permanently tax free (as long as your cost basis is above $0).
MLP Taxes: Here’s Where Return of Capital Starts to Really Matter
Master Limited Partnerships are known for having extra tax complexity due to their use of K-1 tax forms instead of 1099s (with the notable exception of LNG Tanker MLPs such as GasLog Partners, as well as MLP general partners which generally issue 1099s).
The reason for this is because, much like REITs, MLPs are generally very capital-intensive businesses (mostly energy pipeline or shipping companies), which means they have massive amounts of depreciation that lower their GAAP earnings.
Since the business model of MLPs is to payout the vast majority of distributable cash flow, or DCF (MLP version of free cash flow and equivalent to a REIT’s AFFO), as distributions to unit holders (i.e. investors), the distributions are almost always greater than EPS, making the vast majority of the payout ROC.
While that may be great in taxable accounts, in the sense that you get a lot of deferred taxes, it does make MLPs generally unsuitable for tax-deferred accounts.
That’s due to two reasons. First, because IRAs and 401Ks don’t get taxed on dividends and distributions until you start withdrawing funds from the accounts, you don’t gain a tax advantage by owning these kinds of stocks.
The second reason is something called unrelated business taxable income, or UBTI.
If your portfolio creates over $1,000 of UBTI in a year, then you have to both report it (via a 990-T form) to the IRS and pay taxes on it at your top marginal tax rate, even if you own the MLP in a tax-deferred account.
In addition, keep in mind that because most MLPs, including blue chips like Enterprise Products Partners (EPD), are involved with energy transportation (specifically natural gas, oil, natural gas liquids or NGLs, and refined petroleum products), there could be a time limit on these kinds of investments.
Specifically, as the world moves towards cleaner, more renewable energy, such as solar, wind, and hydro power, eventually demand for fossil fuels could peak and wane.
No one knows for sure but, unlike some REITs which might potentially be owned forever and thus benefit from the permanent tax deferral of ROC, MLPs could have a limited time horizon of 15 to 30 years.
To put it another way, be aware that, if you choose to invest in MLPs, you could be more likely have to sell them within your lifetime and thus end up paying taxes on the ROC portion of the distributions you receive.
Taxes on YieldCo Distributions
YieldCos are pass-through entities similar to MLPs and REITs, in the sense that they can avoid paying taxes as long as they payout almost all of their cash available for distribution, or CAFD, (YieldCo equivalent to REITs’ AFFO or MLPs’ DCF), to investors.
Most YieldCos consist of renewable energy assets, making them the equivalent of solar, wind, or hydropower utilities, whose assets are generally under long-term, fixed power purchase agreements with large utilities for terms of 20 to 30 years.
Like MLPs and REITs, the capital-intensive nature of these stocks means that they have a lot of depreciation that lowers GAAP EPS and results in a large portion of their dividends being ROC.
However, unlike MLPs, most YieldCos such as NextEra Energy Partners (NEP),or 8Point3 Energy Partners (CAFD) issue 1099-DIV forms instead of K-1s (and can be owned in tax-deferred accounts due to a lack of UBTI).
As with REITs, YieldCo dividends are unqualified (taxed at your top marginal income tax rate), and the amount of ROC generated by YieldCos can be found in their form 8937, which can located on their websites and tells you how much to reduce your cost basis by.
The form below is from NextEra Energy Partners and informs investors that all cash distributions declared in 2016 represent a return of capital. The company gives the amount to reduce your cost basis by for each distribution that was declared.
However, like with REITs, the ROC tax deferment could potentially prove permanent given the potentially long growth runway of renewable energy utilities.
In other words, unlike with fossil fuel-based MLPs, the best quality yieldCos could benefit from the continued adoption of cleaner energy sources, proving to be “buy and hold forever” dividend growth stocks and allowing you to permanently defer much of the taxes you’d normally owe on these unqualified dividends.
Business Development Companies: Distribution Taxes
Like most pass-through stocks, business development companies (BDCs) avoid paying taxes at the corporate level by paying out the vast majority of their profits and cash flow to investors. That means that their dividends are unqualified with a minor exception.
Specifically, if a BDC takes equity stakes in the companies it lends to, such as is the case with Main Street Capital (MAIN), then a portion of the dividend may come from capital gains or the qualified dividends the BDC gets from the shares it owns in its clients.
Put another way, a portion of some BDCs can be taxed as qualified dividends or long-term capital gains (the same thing for tax purposes) rather than ordinary income.
The breakdown of how much of each quarter’s distribution is qualified or unqualified can be found on a BDC’s website.
As you can see in the table below from Main Street Capital, the qualified / unqualified / capital gain mix can be highly volatile from one distribution to the next.
However, most of the time the distribution will be unqualified, except for those quarters in which the company sells the equity it owns in its clients. Close to 90% of Main Street Capital’s distributions declared in 2015 were unqualified.
Taxes on International Dividend Stocks / ADRs
International dividend stocks are a great way to diversify one’s income and gain exposure to non-U.S. economies, many of which are growing at faster rates than ours.
But when it comes to taxes, there are some very important things to keep in mind.
Most foreign stocks or American Depository Receipts, or ADRs (which allow foreign companies to trade on U.S. exchanges in U.S. dollars), will automatically withhold foreign taxes on the dividends that international corporations pay.
The foreign withholding rate can vary wildly. Here is the withholding tax rate for some of the largest countries:
- Canada: 25%
- China (mainland): 10%
- France: 30%
- Germany: 26.375%
- India: 0%
- Ireland: 20%
- Italy: 26%
- Japan: 20.42%
- Mexico: 10%
- Russia: 15%
- Saudi Arabia: 5%
- Spain: 19%
- Switzerland: 35%
- Taiwan: 20%
- U.K. REITs: 20%
You can view the complete list of withholding tax rates for every country here.
The good news is that, thanks to foreign tax treaties with the U.S., often the actual rate of foreign taxation is much lower.
For example, the U.S. has a tax treaty with Canada that results in a 15% tax for dividends withheld for Canadian taxes, not 25%.
For shares held in taxable accounts, you can deduct any foreign withholdings from what you owe the IRS, as long as your foreign withholdings are equal to or under $300 or $600 for single or married/joint filers, respectively.
That’s if you are using the standard and least complex 1040 Federal Income Tax form. If your foreign withholdings are above that limit, then you’ll need to fill out form 1116, assuming you want to maximize your tax credits.
The important thing to remember about this foreign tax credit is that any year’s benefit can’t be more than your U.S. tax liability.
For example, say your total U.S. tax liability is $1,000 and your foreign tax liability is $500. In that case, you can deduct the entire $500 and pay only $500 to the IRS.
But if your foreign tax liability is $1,000 and your U.S. tax liability is $500 then you can’t claim the full amount (which would result in the U.S. government sending you a $500 check).
Instead you can deduct $500, bringing your total U.S. tax liability to zero, and then carry forward the $500 remaining foreign tax liability into the future, but for no more than 10 years.
However, keep in mind that claiming this credit might not be so easy. For example, if your foreign tax withholdings are above the $300/$60 limit, in order to do so you need to fill out form 1116, which can get incredibly complicated.
In fact, the instructions for form 1116 are themselves 24 pages long. If you aren’t willing to go through this form for each and every one of your foreign dividend stocks, then you can simply choose to deduct your foreign tax withholdings (which show up on box 6 of your 1099).
But as with the case of all deductions, the amount you can reduce your U.S. taxable liability by is not the full amount, but only your top marginal tax rate.
For example, if you’re single and making $35,000, putting you in the 15% tax bracket, and your total foreign dividend withholdings were $1,000, then the maximum you can deduct from your U.S. taxes is $150 (15% x $1,000 foreign dividend withholdings).
On the other hand, it might not be worth your time to go through form 1116 for every foreign dividend stock just to get that extra $850, especially if you own a lot of foreign companies.
Investors considering foreign stocks should be aware that if they hold such shares in tax-deferred accounts such as IRAs and 401Ks, they can’t use the foreign tax credit or deduction on foreign investment income.
Of course, the biggest problem with foreign dividend stocks is that, due to over 60 different tax treaties with nations all over the world, each of which is slightly different, many investors end up being taxed by both governments.
For example, while Canadian companies will automatically reduce the withholding rate to 15% without any additional paperwork on an investor’s part, Swiss companies will only honor the 15% tax treaty rate if your broker or wealth manager fills out separate paperwork ahead of time.
And to make matters even more frustrating, according to Richard Barjon, a senior tax manager specializing in international tax issues at WeiserMazars, sometimes a foreign company “will want its own certificate signed by the IRS confirming that the U.S. tax was paid on the foreign income. For investors with a lot of foreign dividend stocks keeping abreast of each country’s tax laws and even each company’s individual paperwork requirements can become ludicrously frustrating.”
Even with far more dividend-friendly countries, if you want to minimize your foreign tax burden you still might need to deal with form 1116.
In fact, about 90% of U.S. investors end up forgoing these tax credits, resulting in about $200 billion in over taxation each year!
The good news is that some brokers, such as Morgan Stanley (MS) and JPMorgan Chase (JPM), will automatically consolidate all of their clients’ investments into aggregated omnibus accounts and file all the tax minimizing paperwork for them.
However, other brokers such as Fidelity and Vanguard use global custodian banks to handle the taxes for their clients. Usually the custodians won’t automatically do the heavy lifting for you.
Which means that, unless you have a private wealth manager or accountant who can keep abreast of foreign tax law (since 2010, 13 nations have increased their withholding rates), many U.S. dividend investors are sadly forced to choose between minimizing their tax filing hassle (by deducting foreign taxes and leaving money on the table) or choosing to go the more complex form 1116 route to minimize their foreign tax burden.
What about foreign mutual funds? While this can be a good idea if you go with a U.S.-based fund or ETF, you want to be careful to avoid foreign-based mutual funds, which the IRS classifies as passive foreign investment companies, or PFICs.
The tax regulations for PFICs are even more complex and byzantine, but generally the dividends from such investments are treated as ordinary income and thus taxed at your top marginal tax rate.
As you can tell, taxes on dividends paid by foreign companies are very complicated. The dividend amounts and yields displayed on our site for ADRs are net of withholding taxes, providing a more realistic look at the amount of cash you would actually receive.
My personal preference is to stick with U.S.-based multinationals if I want to gain exposure to international markets.
Taxes on Preferred Stock Dividends
Preferred shares are a hybrid of stock and bonds in that they have a fixed dividend, a par value, and often a callable date, at which point the company can choose to buy them back at the par value.
Most preferred shares have no voting rights but the dividends are generally cumulative, meaning that if a company has to suspend the dividend for some time, the dividends continue to accrue.
Then, when the company is able to once again pay a dividend, it can’t pay common shareholders until it has paid back preferred investors in full.
Preferred dividends are generally qualified and taxed at a lower rate than ordinary income unless they are composed of ROC, which is stated on the 1099-DIV form the company sends out each year (and is usually available online).
In that case, as with MLPs, REITs, and YieldCos, the ROC component is deducted from the cost basis and taxed as a capital gain when the shares are sold or called (bought back by the company).
Note that the preferential tax treatment for capital gains only applies to long-term capital gains, meaning on shares you have held for at least one year. Capital gains on shares held for less than a year are taxed as ordinary income – the same as unqualified dividends.
Dividend ETF Taxes
Dividend ETFs have a major advantage over dividend mutual funds in that capital gains are taxed only when the ETF is sold.
In contrast, mutual funds pass on capital gains to investors whenever the shares held by the fund are sold. That means that even if you buy and hold a dividend mutual fund, you are still accruing capital gains that you will be liable for.
As far as the taxes on the ETFs’ dividends go, that depends on what kind of ETF we are talking about.
For example, the Schwab U.S. Dividend Equity ETF (SCHD) is arguably the gold standard of high-quality, blue chip dividend stocks.
It tracks the Dow Jones 100 Dividend Index, meaning it selects only the top 100 financially healthy, non-REIT, MLP, or preferred shares that have been paying a dividend for at least 10 years. Thanks to its composition, this ETF pays only qualified dividends.
On the other hand, REIT, MLP, or high-yield ETFs, such as the Vanguard REIT Index Fund ETF (VNQ), can and do include ROC as part of their dividends. These parts of their payouts are taxed differently, as previously explained.
However, the good news for investors in these kinds of ETFs is that all of them use traditional 1099 forms, meaning that even if you own an MLP ETF, for example, you can forgo the added complexity of the K-1 form.
What about foreign dividend ETFs? Well, there is both good and bad news here.
On the plus side, as long as a company is headquartered in a country that has a tax treaty with the U.S. (pretty much everyone except Singapore, Taiwan, Malaysia, Hong Kong, Brazil, and Chile), then the dividends are qualified.
However, the downside is, as we’ve seen with foreign dividend stocks, that you’ll still have to deal with foreign tax withholdings, including all the potential complexity of the form 1116.
As for bond ETFs, bond payments are not considered qualified, which means that their dividends are taxed as ordinary income.
Essentially, you need to be aware of which types of securities a dividend ETF is invested in to understand the tax ramifications.
Taxes on Closed-end Funds (CEFs)
CEFs are a hybrid of mutual funds and ETFs. Like a mutual fund, they are pools of capital run by active fund managers (and thus usually have much higher fees than ETFs).
However, unlike mutual funds, the pool of capital is fixed so shareholders can’t withdraw funds. They can only sell their shares in the CEF.
This is in contrast to mutual funds, in which redemptions can force fund managers to sell shares in underlying securities and thus create negative tax and performance implications.
And like ETFs, CEFs trade throughout the day, while mutual funds are priced once per day, after the market closes.
The kind of dividends received from CEFs, like with ETFs, can be qualified dividends, unqualified dividends, capital gains, or ROC. It largely depends on the kind of CEF you own.
However, it’s important to note that, unlike ETFs, in which ROC is generally benign and merely reduces the cost basis of your shares, CEFs often have “managed distribution” policies – in order to maintain investor interest fund managers can, and often do, payout more in dividends than the fund generates in the form of income or capital gains.
This is a highly destructive form of ROC because it comes out of the pool of capital that the managers have to invest with on behalf of shareholders.
In other words, this kind of ROC is equivalent to an unsustainable dividend that will eventually need to be cut.
Many CEFs have declining dividends (and share prices) over time because their investable pool of capital, which is fixed, shrinks over time if management issues too many ROC-based dividends.
In order to avoid these kinds of value traps investors will want to make sure that CEFs meet three criteria:
- Rising net asset value (NAV/share) over time, proving that management is able to generate rising shareholder value
- Rising dividends over time, proving that any ROC isn’t destructive and generating a capital gain catalyst
- Dividends that include very little ROC (Morningstar is a great source for seeing what a CEF’s historical dividends are comprised of)
Taxes on Dividends: Don’t Be Discouraged!
Don’t let the complexity of taxes on dividends discourage you – dividend growth stocks are still very much worth owning.
History has shown us that dividend growth stocks have generally been, and will likely continue to be, an investor’s best hope of achieving long-term financial independence.
Take a look at the long-term outperformance of S&P Dividend Aristocrats, for example (see below). Or the substantial contributions dividends have made to the market’s overall total return during the past century.
Thanks to online services such as TurboTax, it has never been easier for the average investor to benefit from the long-term wealth compounding of dividend stocks while minimizing the hassle that comes around each tax season.
The key is understanding how each different type of dividend stock is taxed and which type of account it should be owned in to avoid surprises come tax time.