We offer some tips for tax-conscious yield-seekers along with some traps to avoid.
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By Christine Benz | 03-17-11 | 06:00 AM | Email Article

Dividend-paying stocks have enjoyed a renaissance during the past several years. Following the late 1990s and early 2000s--an era marked by the squandering of shareholder assets on misguided acquisitions and inflated pay packages--investors have gone into "show me the money" mode. The high-profile blowups of many financial stocks notwithstanding, dividend payers generally outperformed nondividend payers during the financial crisis.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Further burnishing dividend payers' appeal is the currently benign tax treatment of dividends--those in the 25% tax brackets and above pay taxes at a 15% rate on qualified dividends, while those in the 10% and 15% tax brackets pay no taxes at all on such dividends.

That's a big attraction, but investors need to mind their p's and q's before embracing dividend payers for their taxable accounts. Here are some tips and traps.

Understand the Difference Between Qualified and Nonqualified Dividends
You often hear that the dividend tax rate is either 15% or 0%, depending on your tax bracket. But if it's not the right kind of dividend, you could actually owe ordinary income tax on your dividends--giving your payout a haircut of as much as 35%, depending on your tax bracket. That's because the Internal Revenue Service separates dividends into qualified and nonqualified bins. One big category of nonqualified dividends are those that REITs kick off; while their yields might be lush relative to the income you receive from other stocks, you'll owe ordinary income tax on that income. (Owing to that tax treatment, investors in the typical real estate fund have paid a tax-cost ratio of 1.9% per year during the past decade, far higher than any other equity category.)

Foreign-stock dividends will not necessarily qualify for the low tax treatment, either. Unless a foreign-stock dividend counts as qualified, which usually means that the company is eligible for benefits under a U.S. tax treaty or trades as an ADR, you'll owe ordinary income tax on any dividends received. That's why it pays to do your homework before reflexively assuming that all dividends are created equally from the standpoint of taxation.

Watch Out for Income-Focused Funds
If you buy and hold individual stocks, you can do your homework and downplay nonqualified dividend payers. But if you own stock mutual funds focused on dividend payers--such as those with "Equity Income" or "Dividend" in their names--you won't have the same opportunity to pick and choose. Unless a dividend-focused fund is explicitly tax-managed, the manager's only goal is to maximize income and total return.

That means it's highly possible--even likely--the fund will hold companies that kick off nonqualified dividends, and such a fund may even own some bonds, to boot. (The typical equity-income fund owns about 6% in bonds, the income from which is taxed at investors' ordinary income tax rates.) So before you park an equity-income fund in your taxable account, first spend some time looking under the hood.

Hold MLPs in Taxable Accounts
Most income-producing securities that are a bad bet for a taxable account are just fine for a tax-sheltered vehicle such as an IRA. If you hold income-producing securities within an IRA wrapper and reinvest the income, you won't owe taxes on that income from year to year; you'll only owe taxes when you begin taking distributions during retirement (and you may be able to avoid taxes altogether if you hold your assets in a Roth IRA). The tax treatment of master limited partnerships, however, turns that formula on its head. As I outline in this article, MLPs are a bad bet for an IRA because you'll owe income tax on distributions that exceed $1,000. Instead, an MLP is that rare high-income investment that's a better bet for a taxable account.

Assume It Will Stay This Way
We've gotten spoiled with the low tax rate on dividends. But the current policy has only been around since 2003, and it's set to revert to pre-2003 levels in 2013. That means that dividend income will again be taxed at investors' ordinary income tax rates. If that happens, you might decide you want to get those dividend payers into a tax-sheltered wrapper like an IRA or 401(k) post-haste. After all, it's better to let those dividends compound rather than letting the IRS take a big cut right off the top.

But if you need to trade out of dividend payers at that time, and the securities have appreciated since you originally bought them, you'll owe capital gains on that appreciation. In essence, improving your portfolio's tax efficiency for the future could force you to take a tax hit. Of course, it's possible that Congress could keep dividend tax rates on par with capital gains rates in 2013 and beyond. But it's worth bearing in mind that tax treatment of dividends may not remain as good as it is right now.

Hold Very High Dividend Payers in Taxable Accounts
Even if a company's or fund's dividends are qualified all the way, companies and funds that kick off very high levels of income are still usually best left in your tax-sheltered accounts. That's because you're going to receive that high income stream whether you need the money or not, and in turn, you'll owe taxes on that dividend for the year in which you received it. (If you hold a dividend-paying fund, you'll owe taxes on any dividends paid out, even if you've reinvested those dividends back into the fund.)

By holding nondividend payers in your taxable accounts, by contrast, you won't be on the hook for taxes unless you take action and sell shares. Of course, you might decide that dividend payers' fundamental attractions supersede the tax considerations, but all else equal, dividend payers are less tax-efficient than nondividend payers, even in the current low-tax environment.

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Morningstar - 2011/03/17 - Dividends and Taxes: Dos and Don'ts - <a href="http://www.morningstar.com/articles/author/30-christine-benz.aspx">Christine Benz</a>
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