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Dividends and Taxes: Dos and Don'ts

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, 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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Glaser: What happens if you own these companies in an IRA or some other tax-advantaged account?

Peters: Well, with both the qualified dividend payers and the REITs, to own them in a tax-deferred account is advantageous because you're not obliged to pay tax on those earnings when you receive them. You have the opportunity to reinvest the whole thing and increase your income by owning more shares of a particular company, particular REITs, whatever the case may be, and you are only taxed when you make a withdrawal from the account.

Master limited partnerships, though, it's a little different story. Even though REITs are allowed to pay dividends into tax-deferred accounts and they themselves are not paying federal income taxes, master limited partnerships are taxed in a very, very different way, a whole different part of the tax code. And the government doesn't like for those income allocations to be made to tax-exempt entities. And it isn't just IRAs, it's even things like charitable trusts, are really not able to receive that partnership income.

It's not technically illegal, but in a worst-case scenario, if you receive more than a certain amount of master limited partnership-allocated income in an IRA, your IRA would owe tax and have to file its own tax return. You might have to cut a check from your IRA to pay tax that you would've owed as a regular taxable shareholder of a master limited partnership. So it gets very messy. My recommendation is to just not do it.

Glaser: So even if your broker says that you can do it, definitely something to stay away from?

Peters: Anybody who says that you can do it or there's a good way to get away with it, I would check with a tax advisor first because the way that master limited partnerships work is that you may be allocated, in fact, taxable losses, have no taxable income even though you're receiving cash distributions in the first couple of years you own a partnership because there's all these big depreciation charges that are front-loaded and you get the benefit of those up-front.

But later on, as those depreciation deductions become less valuable, that taxable loss that you might be allocated is turning into taxable income. And then if you should sell, all of a sudden there's a big catch-up provision where all of the excess depreciation deductions that you might've had or losses that you might've been allocated any particular year, those are all trued up to what you actually got for selling and you could find yourself with a big one-time gain just from a purely tax book perspective. And that's not the kind of situation that you want to run into.

I'm not going to say it's illegal, I'm not even going to say, you know, don't do it ever, ever, ever, but you have to be very, very careful because the limit, $1,000 a year worth of non-qualifying income in an IRA, is low. Even a relatively modest investment, if it turns out to be successful, could bump up against that limit.

Glaser: OK, great. Josh, thanks so much for talking with me today.

Peters: Yeah. Sorry this is so complicated, but just keep in mind, if you remember that MLPs really don't belong in IRAs or 401(k) plans, Roth accounts, things like that, you might save yourself some big headaches down the road.

Glaser: Yeah, great. For Morningstar.com, I'm Jeremy Glaser.