Tax Talk: What to Do With Dividend Payers

Jason Stipp: I'm Jason Stipp for Morningstar.

We recently held a retirement readiness Q&A for Premium Members on Morningstar.com, and we answered a ton of your questions, but we couldn't get to them all.

So today we're playing catch-up with Morningstar's Christine Benz, our director of personal finance. She's going to answer some of the questions about dividends that we didn't have time for during the original Q&A.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: Dividends are a hot topic among our readers. We did get a lot of questions about dividends during the Q&A. We didn't get to quite all of them, but we have few here that we're going to catch-up with.

The first one has to do with the tax treatment for dividends, which may or may not be changing, which is causing quite a bit of consternation for investors--that uncertainty. And the question is, I'm invested in U.S. dividend stocks in a rollover IRA. What should I do to prepare for the potential January 2013 tax increase? Do I need to convert to a Roth IRA?

Before you answer, let's talk about what some of those proposed changes are. What's on the table?

Benz: OK. So, we're seeing a number of tax-related changes. The key one that this reader is homing in on is a change in dividend tax rates.

So, qualified dividends right now for most investors are taxed at 15%. If you're in the 10% or 15% tax bracket, you're actually paying 0% on dividends that you receive. So, that is set to change to investors' ordinary income tax rates across the board, regardless of tax bracket, starting in 2013.

But there is a lot of uncertainty whether Congress might move to actually undo those changes and let the currently low dividend tax rates continue. But that at least is what's on the table, and that's what has a lot of dividend-focused investors concerned, because they've been happily harvesting dividends in their taxable accounts. Well, that will be a big difference, if their taxed rates close to 40% versus what they're paying now.

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Stipp: So, you mentioned in their taxable accounts, so these potential tax increases on dividends would apply to taxable accounts. In this reader's case, though, these dividend-paying stocks or dividend-stock funds are in a rollover IRA, so what's the tax situation there? Is there any potential tax increase that might happen for dividends in that kind of an account?

Benz: No, the short answer is no. So, if you're holding dividend payers within the confines of an IRA, you'll pay taxes when you withdraw money from that IRA, and you'll pay taxes at your ordinary income tax rate.

What happens with dividend taxes doesn't matter, and that's true whether you are invested in a traditional IRA-- oftentimes a rollover IRA is a traditional IRA--or a Roth IRA. The tax treatment that you receive will be the same. If you're in Roth, you will be able to withdraw your money on a tax-free basis during retirement.

Stipp: So, on a year-to-year basis, if this investor isn't taking money [out], and is just accumulating money in that IRA, if the dividend tax rate does go up, it wouldn't affect them right away.

If they are, however, taking money out of that IRA at their regular income tax rate, might that regular income tax rate go up as part of the tax increases that happen potentially next year?

Benz: So, another thing that's on the table, in addition to these dividend tax increases, income tax rates on people in the higher income bands are, in fact, going up in 2013, or set to go up in 2013; we don't know for sure whether that will happen.

So, that does make converting traditional IRA assets to Roth IRA potentially more attractive, because if your tax rate is going up from where it is in 2012, you'd be better off converting in 2012, paying taxes at today's rates, and potentially being able to take tax-free withdrawals from that Roth in the future.

Stipp: So, some interesting things to think about when you're talking about these potential increases in terms of IRAs and the options there.

Another question, Christine, and … this is for a taxable account. The question was, would you sell appreciated dividend stocks this year or wait another year. Given that uncertainty, we just don't know. If I have got a dividend payer that's done quite well for me, should I pull the trigger and sell it now, given that we don't know what's going to happen. What's your take on that?

Benz: There are a lot of different wrinkles to that particular question, because one other tax change that's set to go into effect in 2013 is that we're set to see capital gains tax rates go up, so they will rise, for most investors, from 15% to 20%, and that has a lot of our Morningstar.com users buzzing about, not tax loss harvesting, but actually tax gain harvesting. So, if you have a gain in a security from the time that you bought it, are you better off potentially selling now, paying taxes at today's lower rates, and you could even rebuy down the line and you've reset your cost basis in that security. So, it's an attractive strategy, but I would say, you really only want to look at it if you also have a fundamental reason to consider unloading the stock.

So, in the case of dividend payers, for example, I know that a lot of investors have seen big runups in some of those holdings. They may, for rebalancing or diversification purposes, want to take some chips off the table. In that case, I do think that potentially harvesting that gain can make sense.

Another strategy to bear in mind is that if you are holding dividend payers in a taxable account, it's not a bad year to think about relocating them to a tax-sheltered account. So you may trigger a capital gain to actually sell that security and rebuy it in, say, an IRA, but that may save you money on taxes down the line, because you won't owe taxes on those dividends at higher dividend tax rates on a year-to-year basis if you've got it sheltered within a tax-sheltered account like an IRA.

Stipp: Last question, Christine, also related to dividends, but this one thankfully is not a tax question, which can get a little bit thorny. This is more related to the bucket approach that we've talked about so much, you've written about, and we've discussed in videos before.

"In which bucket does a dividend growth fund belong?" So, a fund that's going to be paying you some income, where would you place that in the bucket scheme? And maybe it's best to start out by saying, just briefly, what kind of buckets do you set up in retirement?

Benz: So the main bucket to have if you're using this strategy is to have some sort of a liquidity bucket, where you are stashing money to fund your near-term expenses. That's anywhere from, say, six months to two years. You've got that in cash or maybe very high-quality short-term bonds and bond funds. That's money that's locked down, ready to go, ready to spend.

The other buckets--and it's sort of up to the investor's discretion to decide how many--would contain slightly longer-maturity, higher-risk securities. So in the construct that we've been talking about with our Morningstar.com users, they've got that bucket number one--that liquidity piece. They've got bucket number two, and in my scheme that's typically core bond types, intermediate-term bonds mainly, but maybe also some balanced funds or dividend-paying equities--high-quality equities for sort of that tail end of bucket number two. And you could certainly also put dividend-paying equities in bucket number three, and that's the long-term piece of the portfolio that's sort of the growth engine.

So, I would say, if you are using a bucket approach, you'd put dividend payers either at the tail end of bucket number two or in bucket number three.

Stipp: So maybe the riskier portion of a bucket number two or a more conservative portion of a bucket number three is a good way to think about that dividend growth fund, then.

Christine, thanks for helping us play clean-up on some of these all-important dividend questions, and for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.