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Dividends Basics: Avoid Dividend Tax Tangles

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

As we enter the New Year, many investors are receiving plenty of tax forms from their brokers.

I'm here with Josh Peters today--he is editor of Morningstar DividendInvestor and also our director of equity-income strategy, to go over some basics of dividend taxation.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Let's start with foreign dividends. I know you get a lot of questions about withholding taxes on foreign dividends and other questions. What sort of special considerations should investors have if they have some dividends coming from abroad or they are thinking of investing abroad?

Peters: Definitely, before you buy a stock that is domiciled in a foreign country, you want to find out what kind of dividend withholding taxes might be imposed by that company's home country.

In the United States, it's pretty simple. If you receive a dividend from a foreign company, typically it's going to be characterized as a qualified dividend, taxed at 15% or 20%, if it's in a taxable account, and then tax-deferred if it's in an IRA or a 401(k) plan, or something like that.

But you also have to be aware of what tax is being levied by the company's home country. For example, if you own Nestle or Novartis, two big and very high-quality Swiss companies, chances are that the Swiss government will withhold 15% of the value of that dividend before it's even paid into your brokerage account as a U.S. shareholder.

Now, that doesn't necessarily mean that Nestle or Novartis or other foreign companies in foreign countries are bad investments, but it does become more sensitive how you own the stock. If you own a foreign dividend-paying stock in a taxable account, then you should be able to recover those withholding taxes using what's called the foreign tax credit on your annual tax return, and it would be enough to offset up to whatever you would owe. So if you would owe an ordinary 15% rate on that dividend paid by, say Nestle, then you get the value of that 15% withholding, and they cancel each other out. If in another country, the tax rate is, say 25%, well, then you're out the difference between the 25% and say the 15% or 20% that you would owe as a U.S. citizen on that dividend.

The worse scenario is that you own the stock in a qualified account, a tax-deferred account like an IRA or a Roth account, 401(k) plan. In those settings, there isn't any way to recover that dividend withholding tax--it's just a deadweight loss.

So, there is an advantage relative in this case to owning those foreign dividend-paying stocks in taxable accounts or to look for British companies. Most British companies do not have any taxes withheld on the dividends paid to U.S. shareholders. That makes a company like Shell or National Grid--some names I've owned and liked for quite a while--advantageous relative to companies that are headquartered in other countries.

Glaser: Another structure that you've warned investors in the past about putting in qualified accounts or master limited partnerships or MLPs. Why is that?

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Peters: MLPs offer a lot of advantages, especially for income-oriented investors. You combine a nice, steady business like a pipeline that throws off lots of cash in a structure that doesn't require the partnership to pay any corporate income taxes. That's a lot of advantages from an income standpoint.

However, the government does want to tax this income somewhere, and if you own MLPs in an IRA or a 401(k), or any kind of a tax-deferred account, the IRS considers that to be unrelated business taxable income. It's not qualified for the tax deferral that makes those tax-deferred accounts so advantageous in the first place.

You receive enough of this UBTI from MLPs that you own or other types of securities that might throw off this type of income, then the account--not you--the account might have to file a return and pay tax. Your broker or yourself, you will have to file a return on behalf of the account.

It's a huge headache. It's really not worth the trouble. It effectively reintroduces that extra layer of taxation that the whole MLP structure is trying to avoid in the first place. It's much better to own these securities in taxable accounts instead where, yes, you will have some extra paper work, but MLP yields are typically higher than what you will find in traditional corporations even in the same lines of business, and in those cases, you can also benefit from deferral.

The taxable income that you're allocated from the partnership is usually going to be lower than the distributions you're receiving in the early years when you own it. The difference eventually becomes taxed, but delaying tax can be almost as advantageous in the long run as avoiding some tax.

Glaser: How about real estate investments trust or REITs? Is there anything investors should keep in mind on that front?

Peters: Yes, here it's much simpler. There's no problem associated with owning a REIT in an IRA or a 401(k) plan, or any other sort of tax-deferred account. In fact, there is some advantage to it. The key difference between REIT dividends and ordinary corporation qualified dividends is that the tax rate is different. REITs under the tax code will typically distribute ordinary income that's taxed at your ordinary top marginal tax rate instead of the lower qualified dividend tax rate of 15% or 20%.

So, if you can own these stocks in your IRA, then you're actually taking advantage of sheltering more of the income from tax than you would be with a traditional corporation. Now, they're fine to own, perfectly legal, you report the dividends on Form 1099. They're pretty simply all around, but in this case, there is that slight advantage to owning it in a tax-deferred account.

Glaser: Josh, I know this is no one's favorite topic, but thanks for walking us through some of these tax issues today.

Peters: Not my favorite topic either, but it's always much better to know and learn what the tax characteristics of these investments are before you buy them as opposed to after.

Glaser: Thanks again, Josh.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.

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