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Investing Specialists

Dividends and Taxes: Dos and Dont's

Taxes on qualified dividends are low, but investors can still encounter unwelcome surprises.

Note: This article is part of Morningstar's November 2015 Income Investing Week special report. This article originally appeared Oct. 1, 2015. 

Hopelessly out of vogue during the dot-com bubble, dividend-paying stocks have soared in popularity over the past decade. Investors woke up to what their grandfathers knew all along: that a company's ability to pay a dividend is a valuable demonstration of its financial wherewithal, and that dividends are a large component of the market's long-run return. Incredibly shrinking bond yields further burnished dividend-payers' appeal, as did the fact that they have outperformed non-dividend-payers by a large margin since 2000. (That time period casts non-dividend-payers in a particularly unflattering light, in that most of the technology companies that were wildly overvalued at the outset of the period did not pay dividends.)

Current tax treatment is another feather in the cap of dividends. While dividend income was previously on equal footing with bond income--taxed at investors' ordinary income tax rates--in 2003 Congress approved legislation that lowered the tax on qualified dividends, putting qualified dividends on par with long-term capital gains from a tax standpoint. That tax reduction became permanent (as permanent as anything in the tax code can be) in early 2013. Currently, investors in 25% to 35% tax brackets pay a 15% tax on qualified dividends, and investors in the 10% and 15% brackets pay no taxes on qualified dividends. Investors whose income surpasses the 35% bracket pay a 20% tax rate on qualified dividends. (There is an additional 3.8% Medicare surtax on all net investment income that exceeds $200,000 for singles and $250,000 for married couples.)

That said, not each and every dividend-payer qualifies for the tax break, and it's not always wise to put dividend-payers in a taxable account, despite their relatively benign tax treatment.

If you've made room for dividends in your portfolio--or you're planning to do so--here are some dos and don'ts to bear in mind.

Do: Know the Difference Between Qualified and Nonqualified Dividends
The Jobs and Growth Tax Relief Reconciliation Act of 2003 created a new category of dividends: qualified dividends, which are eligible for the new lower tax rate. Dividends from most U.S. stocks are qualified. But nonqualified dividends are still dunned at investors' ordinary income tax rates, so it's important to look closely before stashing dividend-payers in a taxable account. 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.

Some foreign-stock dividends won't 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 American Depositary Receipt, you'll owe ordinary income tax on any dividends received.

Do: Check a Dividend Fund's Composition Before Assuming It's Tax-Friendly
Qualified dividends are eligible for the lower tax rate, making dividend-focused funds more tax-friendly than they were in the past. But before you assume that a fund with an equity-income mandate is a good fit for your taxable account, take a closer look at its holdings. Most such funds invest the lion's share of assets in stocks, but they also may hold shares of "other" securities, including convertibles or even bonds, to boost their yields and improve the fund's defensive performance. Income from such securities is taxed as ordinary income, and can boost a fund's tax costs. Take  American Century Equity Income (TWEIX). It's a fine fund and earns a Silver rating, but its stakes in convertible bonds, convertible preferreds, and bonds have boosted its tax costs to more than 2% in the past three years.

Don't: Put High Dividend-Payers in Your Taxable Account If You Can Avoid It
If you need income from your taxable portfolio and are spending your dividends as you earn them, then holding those dividend-payers in your taxable account is reasonable. But if you're reinvesting those dividends in a taxable account, you're effectively paying tax on part of your return before you actually need to. You'll pay tax on your dividends in the year in which you receive them, whether you reinvest the money or spend it. True, you can offset that tax hit by increasing your cost basis to reflect the reinvested dividends. (More on this below.) But you'll still have paid taxes on part of your gain prematurely, thereby violating one of the key tenets of tax management--defer, defer, defer. By contrast, an investor who holds a non-dividend-paying fund that also limits capital gains distributions will owe taxes just at the time of sale (based on the difference between her cost basis and sale price), not before. The right "asset location" (which securities to hold where) is a highly individualized decision, based on time horizon and an investor's choice set, among other factors. But if you're reinvesting dividends, it's ideal to hold those securities in a tax-sheltered account, if possible, while focusing on index funds, exchange-traded funds, or tax-managed funds for the taxable piece of your portfolio.

Don't: Forget to Account for Reinvested Dividends
The preceding point underscores the importance of properly accounting for dividend distributions that you've reinvested: While you pay taxes on those dividends when you reinvest them, you're allowed to increase your cost basis, effectively offsetting the taxes you already paid on that dividend. Mutual fund firms and brokerages are now required to track investors' cost basis and will probably do a better job keeping track of reinvested dividends and capital gains than investors could do with their own spreadsheets. But they've only been required to do so since 2012; if you were reinvesting dividends (or capital gains, for that matter) before that time, you'll need to have records that corroborate whatever cost basis you're using when you sell.

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.