Some dividends are taxed at a higher rate than other dividends. The difference can materially impact your after-tax cash flow.

cash-dividends

When preparing for April 15, many income investors are surprised to discover that not all cash dividends are taxed alike. Some are taxed at a lower rate; some are taxed at a higher rate.

Chalk up the difference to “qualified” status. Dividends deemed qualified are taxed at rate lower than your marginal income tax rates. If your marginal income tax rate is 10% or 15%, you pay no taxes on qualified dividends. If your marginal tax rate falls between 25% and 35%, your tax rate on qualified dividends is 15%. If you’re in the top tax bracket, 39.6%, your qualified-dividend tax rate is 20%.

So how can you tell if your dividends are qualified?

Most C-corporations pay qualified dividends, because these corporations are subject to double-taxation: They are taxed at the corporate level (the dividend are paid from after-tax cash flows) and at the investor level.  To reduce the sting of double taxation, the tax at the investor level is reduced below the marginal tax rate.

For example, Target (NYSE: TGT), McDonald’s (NYSE: MCD), and Microsoft (NASDAQ: MSFT) pay qualified dividends because they are organized as C-corporations and their dividends are subject to double taxation. Investors, therefore, receive a tax break.

In contrast, most dividends and distributions from pass-through entities – MLPs, REITs, partnerships, and royalty trusts – aren’t qualified. The payouts are generally subject to the investor’s marginal tax rate. This makes sense, because payouts are not subject to income tax at the business level, so payouts are normally higher yield.

But it’s not always that clear. The dividend and payouts from many MLPs, REITs, partnerships, and royalty trusts are an amalgam of income, return of capital, and capital gains, so the actual immediate income tax due will be lower than the investor’s marginal income tax rate.  A portion of the payout might be subject to the investor’s marginal income tax rate, and a portion will lower the investor’s cost basis in his investment.

So how can you be assured of the status of your dividends and distributions?

Your brokerage firm can tell you. Many companies also provide dividend information: the dividend history, the current payout, and the qualifying status on their websites. But this can be hit or miss.  Target’s website, for instance, fails to make it readily apparent that the dividend is qualified. (But I know it is.)

When it comes to foreign companies, the waters become muddy. The United States has tax treaties with individual countries, so the tax treatment will vary from country to country.  Depending on the country, dividends may or may not be qualified.

With that said, it’s still possible to pay a marginal income tax rate on a dividend that would normally be qualified.

The IRS mandates that you adhere to a minimum holding period in order to capture the reduced “qualified dividend” tax rate. For common stock, a share must be held more than 60 days during the 120-day period beginning 60 days before the ex-dividend date.

Basically, you must hold the stock for either 61 days before the ex-dividend date, 61 days after the ex-dividend date, or 61 days within the 120-day window to capture the lower tax rate. (To receive the dividend you must buy the stock at least a day before the ex-dividend date.)

Traders need to keep this 120-day window in mind. I’ve had investors ask if it’s worthwhile to trade around the dividend: buy a stock a few days before and sell a few days after the ex-dividend date just to capture the dividend.  Generally, it’s not a good idea to trade around the dividend date if it means the dividend will be subject to your marginal income tax rate.

As with most dealings with taxing authorities, everything is clear as mud, but here’s a mnemonic: If the entity is taxed at the corporate level, the dividend is likely qualified; if it isn’t, the dividend likely isn’t qualified.

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Published by Wyatt Investment Research at