Well, I guess if I’m going to quote Benjamin Franklin, there’s actually two things he claimed as certain—death and taxes. The former is outside the scope of this letter. So, we’re going to take a quick look at taxes.
Taxes are on my mind because I was recently asked if I factor in whether a dividend is considered qualified or ordinary when making my recommendations.
To answer that, we have to look at the difference between the two. To do that, let’s start with the basics of what a dividend is to understand how the designations came to exist.
When a company has net profits, it really only has three things to do with that money:
- Hold it as cash for a rainy day
- Invest it back into the business through acquisitions or R&D
- Reward shareholders through dividends or share buybacks
If a company is in its growth phase, the majority of profits will go right back into the business. Most companies don’t leave a whole lot of money sitting around as cash. Cash is a non-earning asset. Even if a company doesn’t pay a regular dividend, some will pay a special dividend when a cash hoard has built up.
That leaves returning it to shareholders in one form or another.
An Incentive to Pay Dividends
The qualified dividend was created in the Jobs and Growth Tax Relief and Reconciliation Act of 2003. The tax rate on these dividends was lowered. Investors were then incentivized to own dividend stocks and hold them longer. In turn, if more investors are looking for dividend payers, more companies would pay out their profits as dividends instead of using share buybacks.
When a dividend is considered qualified, it’s taxed at the long-term capital gains rate rather than ordinary income tax rate. This means a more favorable tax rate of 20%, 15%, or even 0%, depending on your tax bracket. Most taxpayers have a long-term capital gains and qualified dividend tax rate of 15%.
A qualified dividend:
- Must be paid by a US corporation or a qualified foreign corporation that is incorporated in the US, eligible for an income tax treaty with the US, or have a stock readily traded on a US exchange;
- Can not be a capital distribution, reportable as interest income, from a tax-exempt organization, paid on a security held by an employee stock ownership plan, or on payments in lieu of dividends that are not qualified;
- Shareholder must have held the stock for at least 60 days during the 121 period that begins 60 days before the ex-dividend date. This is 90 days during the 181 period that starts 90 days before the ex-dividend date for preferred shares.
That’s a mouthful of words. Just know that most US corporation dividends meet the requirements for qualified dividends. So, it all comes down to your specific holding period.
And anyway, you’re not going to need to track whether your dividends are qualified or ordinary. The custodian of your shares will do that for you. Form 1099-DIV will show qualified dividends in box 1b and ordinary dividends in box 1a.
Does It Really Matter?
So back to the question: Do I take dividend status into consideration? Not really.
Personally, I’m not big on spending a lot of time trying to minimize my personal tax rate. I pay the bill that comes out of the tax software in April and move onto the next task. It also doesn’t matter a whole lot to me if this extra money is taxed at my ordinary rate.
Making sure my dividends are as large as possible without taking on more risk is where I devote my time. At the end of the day, it’s still extra money that I didn’t have to physically work for no matter how it’s taxed. So, I pay the tax and move on.
But if your income streams are from yields of only one or two percent, these taxes can really eat into that money.
The big reason why it doesn’t matter much is that our strategy really doesn’t allow for many ordinary dividends. REITs are considered ordinary dividends, and MLPs are taxed in a different way entirely. But most of our dividends will be considered qualified since we do not trade in and out of our positions quickly.
Our Bedrock Income positions are those I believe you could hold for years or even decades. And even our Current Yield positions usually have a hold time of at least a year. So unless the payout is specifically not eligible to be qualified, most of our dividends will be.
You might also opt to hold your ordinary dividends in an IRA or tax-advantage account. Just remember that MLPs can trigger other tax headaches in those accounts and are better left paid at the full tax rate.
For more income now, and in the future,
Kelly Green
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© Mauldin Economics
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