Many of my friends, relatives and acquaintances who also invest don’t think much about the type of cash distribution they receive from their investments or the attendant tax treatment of that distribution.
Some of them put their 1099 forms and K-1 forms into the proverbial shoeboxes and hand them to their tax preparers at tax time, never giving a thought to the types of distributions they receive or the taxes that they will pay on those distributions. Heck, they are all just dividends, right?
While I don’t believe in specifically tailoring one's investments to minimize the tax consequences, it is important for investors to understand the basic categories of cash distributions their investments pay out and understand how those distributions are taxed. Dividend taxes matter.
It is important because those distributions are not “just dividends” and how those distributions are taxed varies significantly. In this article, I will provide a brief overview of the most common types of cash distributions and provide some discussion of how each type is taxed as well as how it will affect how much of that distribution you get to keep.
Not 'Just Dividends'?
There are five common types of cash distributions that investors receive from their investments:
- Interest distributions – These payments originate from some type of debt security (bonds, bond funds, bank deposits, notes, mortgages, etc.). With the exception of tax-exempt municipal bonds and bond funds, interest payments are typically treated by the IRS as ordinary income subject to earned income tax rates.
- Capital gains distributions – These payments generally originate from gains or losses on the sale of property or securities (stocks, bonds, real estate, commodities, other real property). Capital gains are either long term if the property/security was held for more than one year or short term if held for less than one year. Long-term capital gains have a preferential tax treatment in that they are subject to a lower federal tax rate than is applied to earned income. Short-term capital gains are treated by the IRS as ordinary income subject to earned income tax rates.
- Ordinary dividends – These payments generally originate from the earnings of corporations and are paid out to the corporations’ shareholders. It is important to note that a large fraction of the distributions from real estate investment trusts (REITs) are ordinary dividends. As of 2015, 66% of REIT distributions were classified as ordinary dividends, 22% of REIT distributions were classified as long-term capital gains, and the remaining 12% of REIT distributions were classified as return of capital (ROC) which is discussed below.
- Qualified dividends – These payments generally originate from the earnings of corporations that also meet specific criteria for their dividends to be “qualified.” For dividends to be qualified, they must be issued by a U.S. corporation, by a foreign corporation that readily trades on a major U.S. exchange or by a corporation incorporated in a U.S. possession. The shares must have been owned by the investor for more than 60 days of the “holding period” which is defined as the 121-day period that begins 60 days before the ex-dividend date, or the day on which the stock trades without the dividend included in the stock price. Qualified dividends are taxed preferentially at the lower long term capital gains tax rates.
- Return of capital (ROC) – These payments generally originate from depreciation of assets (REITs and MLPs), drawdown of reserves (oil and gas royalty trusts), spinoff of part of a company with new shares issued and payments from structured products (closed-end funds) that are distributed to share/unit holders. ROC is often misunderstood as a tax-free distribution because the distribution itself does not result in taxes owed. In reality, ROC effectively defers taxes until the underlying security is sold or otherwise dispositioned. ROC reduces the cost basis of the underlying security and, therefore, the tax on the ROC distribution is paid as a long- or short-term capital gain upon the disposition of the underlying security.
Example: Investor Joe purchased 100 shares of XYZ REIT early in 2014 at $25 per share for an original cost basis of $2,500. When Investor Joe received his 1099-DIV from his broker, the 1099 indicated he received $150 in dividends broken down into $25 in qualified dividends, $105 in ordinary dividends and $20 as ROC. Investor Joe’s cost basis on XYZ will drop from $2,500 to $2,480 as the $20 ROC lowers the XYZ cost basis.
These five common types of distributions are taxed as either ordinary income (interest, ordinary dividends, short term capital gains and ROC for securities held less than one year) or at the lower long-term capital gains rates (qualified dividends, long-term capital gains and ROC for securities held more than one year). OK, this is really great information but what’s it good for?
Qualified versus ordinary dividends
For the balance of this article, we can discuss the tax consequences of receiving qualified dividends taxed at the lower capital gains rates versus ordinary dividends taxed as ordinary income since, as a practical matter, these are the only two distinctions.
This difference in tax treatment is, however, quite significant.
The table below shows the 2016 married filing jointly tax brackets based on taxable income levels for both ordinary income and for capital gains and qualified dividends.
Source: Author
Readers will note that I also included the corresponding AGI based on the assumption of two personal exemptions and the standard deduction as well as a couple of extra “brackets.”
One additional bracket was necessary because the Medicare surtax of 3.8% kicks in at an AGI of $250,000 which is in the middle of one of the standard tax brackets. Another additional bracket was necessary because the phase out of the personal exemption also starts in the middle of one of the standard tax brackets. I didn’t bother with trying to include the effect of the alternative minimum tax as it is too complicated to represent in a simple table.
The most important point to note in the table above is that the tax rate for qualified dividends is lower by a minimum of 10% and a maximum of 19.6% depending on your income. That’s a pretty big difference that can translate into a lot less tax being paid on qualified dividend distributions. The chart below shows three scenarios for taxable income and the resultant tax due.
Source: Author
All three lines are based on the basic assumptions of a married couple filing jointly with no dependents and using the standard deduction (no itemized deductions).
The red line shows the amount of tax due based on all ordinary income (no qualified dividend income or long-term capital gains).
The blue line shows the amount of tax due based on having $15,000 in qualified dividends and/or long-term capital gains with the balance being ordinary income.
The green line represents the tax due under the assumption of all income being from qualified dividends and/or long term capital gains.
Yes, it would be an exceptional case to have $500,000 in income from qualified dividends but it serves to drive home the point that there is a significant advantage to receiving qualified dividends versus ordinary dividends.
For some folks, the graphical representation will not be sufficient to drive home the point that qualified dividends are worth a lot more than ordinary dividends. The table below takes four selected points off the graph to show the income an investor would retain if that income were from qualified dividends versus ordinary dividends.
Source: Author
A retired couple with $80,000 in qualified dividend income and/or long-term capital gains gets to keep $79,295 of that income and has to pay only $705 in federal income taxes. That same retired couple would only get to keep $72,012 and have to pay $7,988 in income taxes if the income was ordinary income and/or short-term capital gains. That’s a difference of $7,283, a significant amount by most standards.
Summary
It is important for investors to understand the different types of distributions they may be receiving from their investments. They are not “just dividends” and the U.S. tax code treats qualified dividends and long-term capital gains much more favorably than ordinary income.
This is key to understanding, for example, that a 4.2% qualified dividend from Verizon (VZ, Financial) may be more valuable than the 4.5% ordinary dividend paid by Welltower (HCN, Financial) after taxes.
(By Dirk Leach)
Disclosure: Not long anything in this article.
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