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Taxes and Dividends - A Case Study

May 14, 202311 min read

Recently on a #BeTheBank call, we were discussing dividends as a form of passive cash flow. They are definitely that. But, like everything when it comes to taxes, there are lots of nuances to take into consideration. So I decided to put this article together to go over dividends with an example from one of my most dividend-heavy clients.

We will go over:
I. Understanding Different Types of Dividends
II. Taxation of Dividends
III. Strategies for Managing Dividend Tax Liability
IV. Bringing it All Together

Different types of dividends can be taxed differently, making it vital for investors to understand the nuances to develop an effective tax strategy.

Consider the case of a successful client of mine who has been investing wisely for many years. Each year, he receives about $80,000 in dividends. However, this income isn't as straightforward as it seems. Approximately $35,000 of these dividends are REIT non-dividend distributions, and about 90% of the remaining dividends are qualified dividends. Let's delve into these different types of dividends, their tax implications, and strategies to manage the tax liability associated with them.

I. Understanding Different Types of Dividends

Investors often look to dividends as a source of steady income. But not all dividends are created equal. There are several types, each with its own tax implications. Let's take a closer look at three types of dividends that are particularly relevant to our client: Real Estate Investment Trust (REIT) non-dividend distributions, qualified dividends, and non-qualified dividends.

a. REIT Non-Dividend Distributions

REITs, Real Estate Investment Trusts, are companies that own, operate, or finance income-producing real estate. There are many different flavors of REITs depending on what kinds of income-producing real estate they own. Some focus on industrial property, some on commercial property, some on medical property, some on residential property, and more. They're required to distribute at least 90% of their taxable income to shareholders annually, and these distributions often come in the form of dividends. However, sometimes, a portion of these distributions is classified as a non-dividend distribution, also known as a return of capital.

A return of capital isn't a dividend from profits; instead, it's a return of the original investment. From the perspective of our client, it's like the REIT is giving a part of his initial investment back. These non-dividend distributions aren't usually subject to taxes when received. Instead, they reduce the cost basis of the investment - this is important.

Cost basis is the number used in comparison to proceeds on sale to determine profit. For example, if our client initially invested $100,000 in a REIT and received $10,000 in non-dividend distributions, his new cost basis would be $90,000. This lowered cost basis would potentially result in higher capital gains when the shares are sold. An investor might think that a REIT bought for $100,000 and sold for $100,000 would result in no profit and no taxes. But if the investor received the $10,000 in non-dividend distributions while holding the REIT, the actual calulation for tax purposes will be $100,000 proceeds minus $90,000 cost basis for a taxable gain of $10,000.

b. Qualified Dividends

Qualified dividends are typically those that are paid by U.S. corporations or qualified foreign corporations, on shares that are held for a specified period of time, known as the holding period. This holding period is usually 60+ days that beyond that 60 days right before the 60 days before the ex-dividend date.

The reason why investors like our client might prefer qualified dividends is that they are subject to lower tax rates. Qualified dividends benefit from being taxed at long-term capital gains rates of 0%, 15%, 20%, or 23.8%, which are typically lower than the ordinary income tax rates that apply to non-qualified dividends. For our client, who has around $40,500 in qualified dividends ($80,000 total dividends - $35,000 REIT non-dividend distributions, and 90% of the remaining $45,000), this distinction could mean significant tax savings.

c. Non-Qualified Dividends

Non-qualified dividends, also known as ordinary dividends, are those that do not meet the requirements to be classified as qualified dividends. They might come from a type of entity that doesn't qualify, such as a real estate investment trust (REIT), or the shares might not have been held long enough to meet the holding period requirement. Often times, these unqualified dividends come from new shares acquired through a dividend reinvestment program (DRiP). As the new shares are acquired each month or quarter that a dividend is paid out the 60-day qualification period starts over again on those new shares.

For simple numbers, if you have 100 shares of stock XYZ and get a 5% dividend (5 shares) and reinvest that dividend, you will then have 105 shares. The next time around, you will have a dividend of 5.25 shares. The 5 from the prior stock holding will be qualified and the 0.25 from the newly acquired stock will be unqualified.

In our client's case, the remaining 10% of his dividends after REIT non-dividend distributions, amounting to about $4,500, are non-qualified. These dividends will be taxed at his ordinary income tax rate, which could be significantly higher than the rates for qualified dividends.
Understanding the different types of dividends and how they are taxed is crucial for efficient tax planning. As we've seen in our client's case, the type of dividend can greatly impact the tax liability, which ultimately affects the overall return on investment. In the next section, we'll delve into the taxation of these different types of dividends in more detail.

II. Taxation of Dividends

Taxation of dividends is a critical aspect of investment planning, as it can significantly impact an investor's net return. In this section, we'll explore how each type of dividend we previously discussed—REIT non-dividend distributions, qualified dividends, and non-qualified dividends—is taxed.

a. Taxation of REIT Non-Dividend Distributions

As mentioned earlier, REIT non-dividend distributions, or returns of capital, are not typically taxed when received. Instead, they reduce the investor's cost basis in the REIT shares. This reduction in cost basis can result in a higher capital gain (or lower capital loss) when the shares are eventually sold.

For our client, his $35,000 in REIT non-dividend distributions would reduce his basis in his REIT shares by the same amount. When he decides to sell these shares, the lowered basis could result in a higher capital gain, which would be taxed at the long-term capital gains rate if he has held the shares for more than one year.

b. Taxation of Qualified Dividends

Qualified dividends are favorably taxed at the long-term capital gains rates, which are generally lower than ordinary income tax rates. The rates for long-term capital gains—and thus for qualified dividends—are 0%, 15%, or 20% (with a potential extra 3.8% of Obamacare taxes), depending on the investor's taxable income.

The threshold for the different qualified dividend tax rates is essentially your tax bracket, which will vary depending on your filing status and taxable income.

If you are in the 10% or 12% bracket, you'll pay the 0% qualified rate.
If you are in the 22%, 24%, 32%, or half-way through the 35% bracket, you'll pay the 15% qualified rate.
If you are in the upper portion of the 35% bracket or higher, you'll pay the 20% qualified rate.

The 3.8% Obamacare tax (net investment income tax technically) kicks in at different levels depending on your filing status:
Single: $200k
Head-of-Household: $200k
Married-filing-Separately: $125k
Married-filing-Jointly: $250k
Qualifying Widow(er) with dependent child: $250k

Quick refresher on tax brackets:

The US uses a graduated income tax system. That means that as you make more taxable income, you pay higher and higher rates on that additional taxable income.

If you are a Single filer you'll pay:

10% on the first $11,000 of taxable income,
12% on $11,001 - $44,725 of taxable income,
22% on $44,726 - $95,375 of taxable income,
24% on $95,376 - $182,100 of taxable income,
32% on $182,101 - $231,250 of taxable income,
35% on $231,250 - $578,125 of taxable income, and
37% on taxable income above $578,126.

As an example, if a Single filer has $110,000 of taxable income that filer will pay (10% x $11,000) + (12% x $33,724) + (22% x 50,649) + (24% x $14,624) = $19,800. So the bracket is 24% (highest taxed portion) but the overall effective tax rate is 18%.

For our client, with about $40,500 in qualified dividends, the applicable tax rate would depend on his total taxable income for the year, including these dividends. If his taxable income puts him in the 15% long-term capital gains bracket, for instance, his tax liability on these dividends would be about $6,075 ($40,500 * 15%). This client has had good years and bad years even as the dividend portfolio continued to churn out income. Some years the client has paid 0% on qualified dividends and some years 15%.

c. Taxation of Non-Qualified Dividends

Non-qualified dividends do not enjoy the lower tax rates that apply to qualified dividends. Instead, they're taxed as ordinary income. This means they could be subject to a higher tax rate, depending on the investor's income level and filing status.

In the case of our client, his approximately $4,500 in non-qualified dividends would be taxed at his ordinary income tax rate. If he falls into the 24% tax bracket, for example, his tax on these dividends would be about $1,080 ($4,500 * 24%).

It's important to be aware that different types of dividends are subject to different tax treatments. We are reviewing here three of the most common types of dividends, but there are more like 199A dividends, capital gain distributions, specified private activity dividends, and more. A sound understanding of these differences is essential for effective tax planning and can significantly affect an investor's after-tax return. In the next section, we'll explore strategies that can potentially reduce the tax burden on dividend income.

III. Strategies for Managing Dividend Tax Liability

Effective tax planning can help to reduce the tax burden on dividend income. Here, we'll discuss a few strategies that could potentially be beneficial to investors like our client. Always keep in mind that individual facts and circumstances are different for each person. What applies to you may not be the same as what applies to your friend, neighbor, or our client example here.

a. Tax-Efficient Investing

Tax-efficient investing involves placing investments in the right types of accounts based on their tax characteristics. Generally, it might make sense to hold investments that produce qualified dividends in taxable accounts, as these dividends are taxed at lower rates. On the other hand, investments that generate non-qualified dividends might be better held in tax-advantaged accounts like IRAs or 401(k)s, where the dividends can grow tax-deferred or potentially tax-free, depending on the type of account.

For our client, this might mean holding his REITs in a tax-advantaged account to defer tax on the non-qualified dividends they produce if the plan is to hold them long enough to erode the cost basis to zero.

b. Tax-Loss Harvesting

Tax-loss harvesting involves selling investments at a loss to offset capital gains. This strategy could potentially be beneficial for our client in managing the tax implications of his REIT non-dividend distributions. If he sells REIT shares at a gain, he could offset this gain with losses from other investments, potentially reducing his overall tax liability.

c. Charitable Giving

If our client is charitably inclined, he might consider donating some of his appreciated securities. If the securities have been held for more than one year, he could potentially deduct their full fair market value as a charitable contribution, thereby reducing his taxable income. Moreover, he would avoid capital gains tax on the appreciation, which could be particularly beneficial for shares of REITs with a reduced basis due to non-dividend distributions.

There are advanced tax strategies of setting up your own charitable foundation if the numbers are large enough, but that goes beyond the scope here.

d. Qualified Dividend Investing

Given the favorable tax treatment of qualified dividends, another strategy our client could consider is investing more heavily in stocks that provide qualified dividends. By doing so, a larger portion of his dividend income would be taxed at the lower long-term capital gains rates, potentially reducing his overall tax burden.

While taxes on dividends are an inevitable part of investing, several strategies can help to manage and potentially reduce this tax liability. The best approach depends on individual circumstances, so investors should consider seeking personalized advice from a tax professional or financial advisor.

IV. Bringing it All Together

Investing in dividend-paying assets can be a rewarding strategy, providing a regular income and potential capital appreciation. However, understanding the tax implications of these dividends is crucial for estimating the net return and making the most of your investments.
In the case of our client, his diverse sources of dividend income—REIT non-dividend distributions, qualified dividends, and non-qualified dividends—each bring their unique tax considerations. Through strategies like tax-efficient investing, tax-loss harvesting, charitable giving, and investing more in assets that yield qualified dividends, he can potentially reduce his tax liability and keep more of his hard-earned income. 

In one of the most recent years, this client paid 0% on the REIT non-dividend distributions, 0% on the qualified dividends, and 12% on the non-qualified dividends. That comes out $540 in taxes on a cash flow of $80,000 for an effective rate of 0.675%. Pretty good.

Remember, everyone's financial situation and investment goals are unique, and tax laws can be complex and change frequently. Therefore, it's always a good idea to consult with a financial advisor or tax professional to understand the best strategies for managing dividend income and its associated tax implications.

#taxes #dividends #PassiveIncome

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Neal McSpadden

Neal went from owing the IRS over $1,300,000 to Zero and in so doing discovered the world of tax planning. Since 2011 he's helped tens of thousands of clients save hundreds of millions of dollars on overpaid income taxes.

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