Especially since the U.S. tax code has grown into one of the largest and most convoluted parts of our government.
Let’s take a detailed look at all of the most important considerations you need to keep in mind when it comes to the tax effects of the various dividend investing vehicles.
- Mutual funds
- International dividend stocks/ADRs
- Dividend ETFs
- Real Estate Investment Trusts(REITs)
- Master Limited Partnerships (MLPs)
- Business Development Corporations (BDCs)
- Mortgage REITs (mREITs)
- Preferred shares
- Closed-end funds (CEFs)
C-Corps and U.S. Mutual Funds Taxes: The Benefits of Qualified Dividends
The lower tax rate associated with qualified dividends can go a long ways. For example, for lower to middle class investors, meaning those with taxable income (gross income minus deductions) less than $39,375 for single people or $78,750 for married people, you won’t pay any taxes on your qualified dividends.
With the median U.S. household income below $60,000 the vast majority of Americans will end up paying just a 15% tax rate on their qualified dividends.
Even if you are in the top tax bracket (a nice problem to have), you’ll still pay 51% less than the top marginal tax rate, which is actually 37% plus the 3.8% Obamacare surcharge for a top tax rate of 40.8%.
Any C-corps in tax-deferred accounts such as IRAs or 401(k)s face no dividend taxes as long as you don’t withdraw any funds. However, when you do start to take money out of such accounts, things get a bit more complicated.
For example, any funds held in a Roth IRA are tax-free forever, including dividends and capital gains, as long as you don’t withdraw funds until after age 59.5 (and you’ve owned the Roth IRA for at least five years).
In other words, if you hold any qualified dividend-paying investments in a non-Roth IRA or 401(k), you lose the tax efficiency of owning those holdings in a taxable account.
Taxes on Dividends Paid by REITs: Now Things Start To Get Complicated
Due to this legal minimum payout requirement, REITs are one of the highest yielding sectors you can find, and thus a popular choice with income investors.
Unqualified dividends usually make up the majority of the payout and are taxed as ordinary income at your top marginal tax rate (except in IRAs and 401(k)s before you withdraw any funds) – not the favorable rate we previously saw for qualified dividends paid by C-corps and mutual funds.
ROC is a bit more complicated. Basically, returns of capital are what the IRS considers any part of the dividend above the REIT’s reported earnings (EPS).
And because GAAP earnings are reduced by depreciation of property, when in reality well-maintained property appreciates in value, GAAP EPS doesn’t represent the actual cash flow that actually funds the dividend paid by a REIT.
Rather, REIT dividends are paid for out of adjusted funds from operations (AFFO), which is generally calculated as Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) minus maintenance capital expenditures. AFFO is similar to a measure of free cash flow for REITs.
Regardless, the IRS considers any dividends paid above a REIT's GAAP EPS to be equivalent to a return of capital (i.e. the company giving back your original investment).
Importantly, ROC isn’t taxed right away. Instead, taxes (at your capital gains rate) are deferred until after you sell your shares. Here’s an example of how ROC works, provided by Investopedia:
“Jennifer decides to invest in a REIT that is currently trading at $20 per unity. The REIT has funds from operations of $2 per unit and distributes 90%, or $1.80, of this to the unitholder. However, $0.60 per unit of this dividend income comes from deprecation and other expenses and is considered a nontaxable return of capital. Therefore, only $1.20 ($1.80 – $0.60) of this dividend comes from actual earnings.
This amount will be taxable to Jennifer as ordinary income, with her cost basis reduced by $0.60 to $19.40 per unit. As stated previously, this reduction in basis will be taxed as either a long- or short-term gain/loss when the units are sold.”
Once your cost basis hits zero, the ROC portion of your dividend is taxed as a qualified dividend. If you pass on your shares to your heirs, the cost basis steps up to the closing share price on the day you die, and the deferred tax benefit is permanent.
Under the new tax code, up to $5.6 million for an individual or $10.2 million for a married couple can be inherited tax free. In other words, you could potentially leave your heirs a substantial income portfolio composed of REITs (or MLPs which also generate ROC) that is generating a very large income stream each year.
Here is a look at Realty Income's (O) 2017 dividend tax allocation (the small capital gain distribution resulted from the firm selling some properties at a profit):
Thanks to a nearly doubling of the standard deduction (to $12,000 for individuals, $18,000 for heads of household, and $24,000 for joint filers), the vast majority of Americans won't be itemizing their taxes.
However, they will still benefit from this new 20% pass-through deduction, at least through 2025 (it expires in 2026). Basically, this new pass-through deduction means that in taxable accounts your REIT dividend tax rate will decline by 20%.
Those in the highest income tax bracket will see effective tax rates on REIT dividends fall from 37% to 29.6% (not counting Obamacare surcharge). Those in lower brackets will still see a 20% reduction but the absolute benefit will be proportionally less.
MLP Taxes: Where Return Of Capital Really Matters
Since the business model of MLPs is to pay out the vast majority of distributable cash flow (similar to free cash flow for an MLP and equivalent to a REIT’s AFFO) as distributions to unit holders (i.e. investors), the distributions are almost always greater than EPS, making the vast majority of the payout a ROC.
First, because IRAs and 401(k)s don’t get taxed on dividends and distributions until you start withdrawing funds from the accounts, you don’t gain a tax advantage by owning these kinds of stocks. Owning MLPs in retirement accounts loses the important deferred tax benefit of ROC.
The second reason is something called unrelated business taxable income, or UBTI.
To put it another way, be aware that, if you choose to invest in MLPs, you could be more likely to have to sell them within your lifetime and thus end up paying taxes on the ROC portion of the distributions you receive (losing the permanent tax-deferred nature of ROC distributions passed onto heirs via the step up of cost basis rule).
Taxes on YieldCo Distributions
However, just because much of the distribution is a ROC doesn't necessarily mean you get a K-1. Some popular YieldCos such as NextEra Energy Partners (NEP) and Pattern Energy Group (PEGI) use 1099 forms, for example.
Others, like Brookfield Renewable Partners (BEP), are technically structured as limited partnerships (LPs) and thus do issue a K-1 form. However, the key difference is that Brookfield Renewable Partners is structured in such a way as to avoid UBTI which means that it, as with most YieldCos, is safe to own in retirement accounts (no UBTI).
Business Development Companies: Mostly Unqualified Dividends But Some Capital Gains Too
Specifically, if a BDC takes equity stakes in the companies it lends to, then a portion of the dividend may come from capital gains or the qualified dividends the BDC gets from the shares it owns in its clients.
For example, Main Street Capital (MAIN) is one of the most popular BDCs, and a relatively high percentage of its portfolio consists of equity stakes in its customers. The capital gain portion of a BDC's dividends is taxed at your long-term capital gains rate rather than ordinary income.
The breakdown of how much of each quarter’s distribution is qualified or unqualified can be found on a BDC’s investor relations website (under "tax information").
As you can see in the table below from Main Street Capital, the qualified / unqualified / capital gain mix can be highly volatile from one payout to the next.
However, most of the time the distribution will be unqualified, except for those quarters in which the company sells the equity it owns in its clients. Close to 80% of Main Street Capital’s dividends declared in 2017 were unqualified.
Taxes on International Dividend Stocks / ADRs
- Australia: 30%
- Canada: 25% (15% effective rate for Americans due to tax treaty)
- China (mainland): 10%
- France: 30%
- Germany: 25%
- India: 0%
- Ireland: 20%
- Italy: 26%
- Japan: 20%
- Mexico: 10%
- Netherlands: 15% (falling to zero starting in 2020)
- Russia: 15%
- Saudi Arabia: 5%
- Spain: 19%
- Switzerland: 35%
- Taiwan: 21%
- U.K.: 0% (20% for REITs)
You can view the complete list of withholding tax rates for every country here.
For example, the U.S. has a tax treaty with Canada that results in a 15% rate for dividends withheld for Canadian taxes, not 25%.
The actual rate of foreign taxation is also usually lower because there is a dollar-for-dollar foreign withholding tax credit that American investors can claim that reduces (and for most people totally offsets) the foreign dividend tax withholding. In these cases, the effective dividend yield is unchanged from what you see on most financial sites.
This limit applies to the simpler 1040 Federal Income Tax form. For foreign withholding amounts over this limit, you need to use the more complex form 1116, assuming you want to maximize your tax credits.
For example, say your total U.S. tax liability is $1,000 and your foreign tax liability is $500. In that case, you can deduct the entire $500 and pay only $500 to the IRS.
Instead you can deduct $500, bringing your total U.S. tax liability to zero, and then carry forward the $500 remaining foreign tax liability into the future, but for no more than 10 years. Any excess liabilities beyond that time frame will roll off (vanish) each year and be replaced by your newest annual carry over.
For example, if your foreign tax withholdings are above the $300/$600 limit, claiming the full tax credit requires filling out the complex form 1116, the instructions for which are 24 pages long.
If you aren’t willing to go through this form for each and every one of your foreign dividend stocks, then you can simply choose to deduct your foreign tax withholdings (which show up on box 6 of your 1099). However, taking this simpler route means that you won't be able to deduct the full foreign tax withholdings from your taxes.
Like with all U.S. tax deductions, the amount they reduce your U.S. tax liability is not the full amount (as with a tax credit), but a partial amount equal to your top marginal tax rate.
For example, if you are single and making $40,000, putting you in the 15% tax bracket, and your total foreign dividend withholdings were $1,000, then the maximum you can deduct from your U.S. taxes is $150 (15% x $1,000 foreign dividend withholdings).
Due to increased complexity, it might not be worth it for some investors to go through the hassle of filling out a form 1116 (or paying an accountant to do it), just to claim that extra $850. That's especially true if you own a lot of foreign-domiciled companies and thus would face a high bill from an accountant to handle this for you.
For example, while Canadian companies will automatically reduce the withholding rate to 15% without any additional paperwork on an investor’s part, Swiss companies will only honor the 15% tax treaty rate if your broker or wealth manager fills out separate paperwork ahead of time.
The good news is that some brokers, such as Morgan Stanley (MS) and JPMorgan Chase (JPM), will automatically consolidate all of their clients’ investments into aggregated omnibus accounts and file all the tax minimizing paperwork for them.
However, other brokers such as Fidelity and Vanguard use global custodian banks to handle the taxes for their clients. Usually the custodians won’t automatically do the heavy lifting for you.
The tax regulations for PFICs are even more complex and byzantine, but generally the dividends from such investments are treated as ordinary income and thus taxed at your top marginal tax rate.
As you can tell, taxes on dividends paid by foreign companies are very complicated. The dividend amounts and yields displayed on our site for ADRs are net of withholding taxes, providing a more conservative look at the amount of cash you would actually receive.
My personal preference is to stick with U.S.-based multinationals if I want to gain exposure to international markets.
Taxes on Preferred Stock Dividends
Most preferred shares have no voting rights but the dividends are generally cumulative, meaning that if a company has to suspend the dividend for some time, the dividends continue to accrue.
Then, when the company is able to once again pay a dividend, it can’t pay common shareholders until it has paid back preferred investors in full.
However, note that qualified dividend treatment requires the underlying company to have a traditional C-corp structure. In the case of pass-through stocks such as MLPs, REITs, and YieldCos, the ROC component is deducted from the cost basis and taxed as a capital gain when the shares are sold or called (bought back by the company).
Dividend ETF Taxes
In contrast, mutual funds pass on capital gains to investors whenever the shares held by the fund are sold. That means that even if you buy and hold a dividend mutual fund, you are still accruing capital gains that you will be liable for.
However, the good news for investors in these kinds of ETFs is that all of them still use traditional 1099 forms, meaning that even if you own an MLP ETF, you can forgo the added complexity of the K-1 form.
On the plus side, as long as a company is headquartered in a country that has a tax treaty with the U.S. (most major countries do), then the dividends are qualified.
As for bond ETFs, bond payments are unqualified, which means that their dividends are taxed as ordinary income.
Essentially, you need to be aware of which types of securities a dividend ETF is invested in to understand the tax ramifications.
Taxes on Closed-end Funds (CEFs)
However, unlike mutual funds, the pool of capital is fixed so shareholders can’t withdraw funds. They can only sell their shares in the CEF.
This is in contrast to mutual funds, in which redemptions can force fund managers to sell shares in underlying securities and thus create negative tax and performance implications.
And like ETFs, CEFs trade throughout the day, while mutual funds are priced once per day, after the market closes.
In other words, this kind of ROC is equivalent to an unsustainable dividend that will eventually need to be cut.
Not surprisingly, many CEFs have declining dividends (and share prices) over time because their investable pool of capital, which is fixed, shrinks over time if management issues too many ROC-based dividends.
To avoid owning these dangerous CEFs you can a site like cefconnect.com to look at the distributions over time and what they are composed of. A CEF that pays out a lot of ROC and has a falling distribution over time is best avoided.
- Rising net asset value (NAV/share) over time, proving that management is able to generate rising shareholder value
- Rising dividends over time, proving that any ROC isn’t destructive and generating a capital gain catalyst
- Dividends that include very little ROC
Morningstar is a great source for checking both the track record of a CEF's NAV/share and what its historical distributions were comprised of. Note that the yield on CEFs (as with ETFs) is net of the expense ratio.
Taxes on Dividends: Complicated But Worth It
The key is understanding how each different type of dividend stock is taxed and which type of account it should be owned in to avoid surprises come tax time.