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By Jeremy Glaser | 02-10-2010 04:50 PM

Dividends and Taxes: Dos and Don'ts

DividendInvestor editor Josh Peters goes over the basics of dividend tax treatment and highlights some potential pitfalls for MLP investors.

Jeremy Glaser: For, I'm Jeremy Glaser. It's that time of year again, that investors are worrying about their taxes, and a question on a lot of people's mind is how dividends are taxed.

Here to discuss it with me is the editor of Morningstar DividendInvestor, Josh Peters. Josh, thanks for joining me.

Josh Peters: Happy to be here.

Glaser: Could you talk a little bit about the different types of dividends and income that investors could see and how those are going to be taxed?

Peters: Sure. When you're looking at common equities, they really fall into three categories. The first is the largest category by far, which is common stocks of traditional, what we call C corporations.

These corporations themselves pay federal income taxes. If they pay a dividend, because that corporation is paying income tax before it even has the opportunity to send a dividend to you, they're what are known as qualified dividends. And for federal income purposes, the tax rate is capped at 15%.

Then there is another group of very popular higher-yielding stocks, perhaps not so popular after the crash, but real estate investment trusts, or REITs. These are not eligible for the qualified dividend treatment because REITs themselves don't pay federal income taxes.

They're exempt from income taxes as long as they pay out at least 90% of their taxable income to their shareholders, so it's the shareholders who wind up being taxed on that income. Those dividends you have to pay tax at your ordinary tax rate, whatever your marginal tax rate is for the particular year.

And then there's another category called master limited partnerships. And these technically are not corporations at all and what you get are actually not even called dividends, they're just called generically cash distributions. In this case, like REITs, master limited partnerships don't pay federal income taxes.

Instead, what they do is they divvy up their taxable income to shareholders, actually technically partners, via a schedule K-1 that you receive in the mail, usually sometime in March. And it's those figures that you consolidate onto your tax return and that is the basis for what you might have to pay tax on, and if you owe tax, then it's paid at your marginal tax rate.

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