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By Josh Peters, CFA and Jeremy Glaser | 01-07-2014 02:00 PM

Dividends Basics: Avoid Dividend Tax Tangles

The differing tax treatments of foreign stock, MLP, and REIT dividends should be on income-investors' radars, says Morningstar DividendInvestor editor Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

As we enter the New Year, many investors are receiving plenty of tax forms from their brokers.

I'm here with Josh Peters today--he is editor of Morningstar DividendInvestor and also our director of equity-income strategy, to go over some basics of dividend taxation.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with foreign dividends. I know you get a lot of questions about withholding taxes on foreign dividends and other questions. What sort of special considerations should investors have if they have some dividends coming from abroad or they are thinking of investing abroad?

Peters: Definitely, before you buy a stock that is domiciled in a foreign country, you want to find out what kind of dividend withholding taxes might be imposed by that company's home country.

In the United States, it's pretty simple. If you receive a dividend from a foreign company, typically it's going to be characterized as a qualified dividend, taxed at 15% or 20%, if it's in a taxable account, and then tax-deferred if it's in an IRA or a 401(k) plan, or something like that.

But you also have to be aware of what tax is being levied by the company's home country. For example, if you own Nestle or Novartis, two big and very high-quality Swiss companies, chances are that the Swiss government will withhold 15% of the value of that dividend before it's even paid into your brokerage account as a U.S. shareholder.

Now, that doesn't necessarily mean that Nestle or Novartis or other foreign companies in foreign countries are bad investments, but it does become more sensitive how you own the stock. If you own a foreign dividend-paying stock in a taxable account, then you should be able to recover those withholding taxes using what's called the foreign tax credit on your annual tax return, and it would be enough to offset up to whatever you would owe. So if you would owe an ordinary 15% rate on that dividend paid by, say Nestle, then you get the value of that 15% withholding, and they cancel each other out. If in another country, the tax rate is, say 25%, well, then you're out the difference between the 25% and say the 15% or 20% that you would owe as a U.S. citizen on that dividend.

The worse scenario is that you own the stock in a qualified account, a tax-deferred account like an IRA or a Roth account, 401(k) plan. In those settings, there isn't any way to recover that dividend withholding tax--it's just a deadweight loss.

So, there is an advantage relative in this case to owning those foreign dividend-paying stocks in taxable accounts or to look for British companies. Most British companies do not have any taxes withheld on the dividends paid to U.S. shareholders. That makes a company like Shell or National Grid--some names I've owned and liked for quite a while--advantageous relative to companies that are headquartered in other countries.

Glaser: Another structure that you've warned investors in the past about putting in qualified accounts or master limited partnerships or MLPs. Why is that?

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