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Lower Your Tax Bill With Equity Tax-Advantaged Funds

Investors should consider these dividend-seeking equity funds for their tax advantages. 

Cara Esser, 03/16/2012

Death and taxes, goes the adage, are the only certainties in life. But another certainty is that most citizens don't like paying taxes and frequently look for sometimes-complicated loopholes to lower their tax bills. But there are a number of easily exploitable methods to lessen the sting of taxes.

As part of the 2003 Bush tax cuts, a cap of 15% was placed on the taxes that individuals paid on "qualified dividends." (For low-income investors, the rate is zero.) Previously, all dividends received were taxed at an investor's ordinary income tax rate. Even now, nonqualified dividends are still taxed at the investor's ordinary income tax rate. The preferential tax treatment of qualified dividends has been renewed twice (once under former President Bush and once under President Obama) and is now set to expire at the end of this year.

There is much uncertainty surrounding the possible outcome of the current tax debate, and it's likely to be a divisive subject in Washington during the election year. Because of this uncertainty, investors may be overlooking a worthwhile category of closed-end funds, or CEFs: the tax-advantaged equity fund. While many equity CEFs distribute a portion of qualified dividends to investors, few focus on these preferential dividends as an integral part of the strategy. Some of these funds also manage capital gains and losses in an attempt to make the portfolio tax-neutral from a capital gains perspective.

Qualified Dividends
Dividends paid by firms must meet several criteria to qualify for the lower 15% tax rate. First, assuming expiration at the end of 2012, the dividend must be paid prior to Dec. 31, 2012. Second, the dividend must be paid by a U.S. corporation, a corporation incorporated in a U.S. possession, a foreign firm in a country that is eligible for benefits under a U.S. tax treaty, or on a foreign firm's stock that can be readily traded on in the U.S. stock market (such as an ADR). Finally, the stock paying the dividend must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first date following the dividend declaration on which the buyer of a stock is not entitled to receive the dividend). Taxpayers can benefit from this lower tax rate on any individual dividend-paying stock holding, assuming the above criteria are met. These rules can be very complicated for ordinary investors to navigate, but the rules are well ingrained for professional portfolio managers who deal daily in this realm. In the context of CEFs specifically, funds receive qualified dividends and pass them directly through to the investor.

Tax-Advantaged Equity CEFs
Like a municipal-bond investment, the biggest benefit of tax-advantaged funds is the ability to boost aftertax distribution, meaning the distribution that an investor keeps after paying all applicable taxes. Unlike a municipal investment, the advantages aren't obvious. Investors must dig though some tax forms to find the percentage of the distribution that qualifies for the lower tax rate. (These forms are released in the first quarter of each year, detailing the previous calendar year's breakdown and made available to both investors and noninvestors on a fund family's website.)

The table below lists seven CEFs categorized as following a tax-advantaged approach to equity investing. The table includes the funds' current distribution rates at net asset value and various aftertax distribution rates.


As an example, Eaton Vance Tax-Advantaged Global Dividend Opportunity ETO has a 6.26% distribution rate. The fund paid the entire distribution from qualified dividend income, so the investor was taxed at 15% instead of the ordinary income tax rate that we assumed was a 28% effective tax rate. This creates an aftertax distribution rate of 5.32% (6.26% x (1 - 0.15)) versus 4.51% (6.26% x (1 – 0.28)).

For funds that do not pay the entire distribution from qualified dividend income, we calculated the aftertax rates assuming realistic rates investors would pay: zero for return of capital (the cost basis is lowered and taxes are deferred), 28% for ordinary income, and 15% for qualified dividends. Nuveen Tax-Advantaged Total Return JTA, for example, paid 55% of its total distribution from return of capital: 5% of the total distribution was from ordinary income and 45% from qualified dividends.

Cara Esser is a closed-end fund analyst at Morningstar.
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