Tax Trade-Offs With Dividend ETFs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The type of dividends you receive can have a big impact on your portfolio's tax efficiency. Joining me to discuss that topic is Adam McCullough. He is a passive strategies researcher at Morningstar.

Adam, thank you so much for being here.

Adam McCullough: Thanks for having me, Christine.

Benz: Adam, let's get into what is a qualified dividend-paying stock and what's a nonqualified dividend?

McCullough: In the U.S., you have qualified dividends and nonqualified dividends. Qualified dividends are taxed at a lower tax rate than nonqualified dividends. There's a few things that you have to meet or …

Benz: Criteria.

McCullough: … that you have to meet to be qualified. In the U.S., it's that the dividend payment is issued by a U.S. corporation, and the fund or the investor has to hold that fund share or stock share for a certain amount of time to qualify as a qualified dividend.

Benz: From a practical standpoint, most U.S. companies paying dividends, those dividends are qualified. But there are a handful of firms whose dividends count as nonqualified. Can you talk about some commonalities or sectors where they tend to cluster?

McCullough: For any publicly traded U.S. firm that's on a major stock exchange, like NASDAQ or the New York Stock Exchange, those dividends should be qualified or will most likely be qualified. For some unique structures like REITs, or real estate investment trusts, where they have to pass through a certain percentage of their income to their end holders--like MLPs or master limited partnerships--those dividends from those types of entities are usually not qualified. Also, other examples are private company dividends or maybe a stock program dividend payment wouldn't be.

Benz: In terms of those nonqualified dividends, I don't qualify for that lower dividend tax rate. I have to pay taxes at my ordinary income tax rate if I'm getting a nonqualified dividend?

McCullough: Exactly. The big issue here is that as an investor you want to pay as little taxes as possible on your dividend income. This was actually established in the tax reforms from 2003 under the Bush era. For a qualified dividend, you are taxed at your long-term capital gain rate instead of your ordinary income rate. For instance, for a bond payment, that's ordinary income, you are taxed at your own ordinary income rate. But for a qualified dividend, it's almost always lower than your ordinary income rate.

Benz: You did some research [available in Morningstar ETFInvestor] where you looked at dividend-focused exchange-traded funds, and you took a look at their portfolios to determine how much do they have in qualified versus nonqualified dividends. If I want to do this homework on my own, where can I find this information?

McCullough: Most fund companies have a tax resource center on their website. If you go there toward the end of the year, they usually have an estimated capital gains distribution section. They also have the most recent year and probably historical qualified dividend percentages. It could just be a PDF or a table which just have a fund and then QDI percentage, which is the percentage of dividend income that that fund throughout that's qualified to be taxed at a lower rate for its fund holders.

Benz: QDI stands for qualified dividend income?

McCullough: Exactly.

Benz: In terms of your findings when you looked at these big ETFs that focus on dividend-paying stocks, what did you find? My cursory glance at the table that accompanied your article was that most of the big ETFs look pretty good from the standpoint of focusing on qualified dividend payers, and in turn lowering my taxes if I hold such a fund in my taxable account.

McCullough: I looked at the 18 largest U.S. dividend funds, largest by assets, and just looked at the last five years of their QDI percentages to see if there's any patterns or where investors can maybe do better from a tax perspective. Most of the large funds have paid 100% of their dividends as QDI in the past five years. The one exception was the SPDR S&P Dividend ETF, SDY is the ticker there. Its five-year average QDI has been 66% versus 100% for its peers in the large-value category. There's not really a great reason as to why. I think it might just be from a portfolio management perspective, they are not managing the tax efficiency of the fund as well as their peers.

Benz: When you look at nonqualified dividend payers versus qualified dividend payers, do you find that the nonqualified dividend payers, they have higher yields attached to them? Is that why perhaps a fund would focus on them?

McCullough: That was one of our hypotheses at the start was that if these funds are chasing after yield, maybe they aren't as focused on the tax treatment of the dividend payment. But for these 18 funds that largely wasn't the case. A second thing that we looked at was the turnover of funds, the idea being that if the turnover is higher, it won't hold the stock long enough for it to have it qualified dividend payment. But in that case, too, there wasn't a strong relationship between a higher turnover and lower QDI percentage.

Benz: If I am an investor in a taxable account and I'm very concerned about tax efficiency and I have equity exposure, a natural question is, dividend-paying fund versus a total market index ETF: Which is my better option if I'm looking for more or less airtight tax efficiency?

McCullough: If it's purely tax efficiency, you are going to want to have the total broad market-cap-weighted fund that's not focused on dividend payments. If you have a market cap tracking fund that pays an average dividend level, even if both of those funds haven't issued cap gains in their history, the one that has a higher dividend yield will be less tax efficient just by nature of throwing off more distributions in the form of dividends.

Benz: They are paying those dividends on a regular basis year in and year out.

McCullough: Exactly. So, even if those are all QDI eligible, it's still going to be less tax efficient than a broader market-cap-weighted fund, but it's going to have a higher yield and more income coming to you as the investors. There's the trade-off that you have to balance as investors if you are that worried about tax efficiency versus the dividend income that the fund is generating for you.

Benz: Adam, thank you so much for being here. Really interesting research.

McCullough: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.