Dividends and taxes

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To lower your tax rate on income, consider owning investments that pay qualified dividends. These dividends are federally taxable at the capital gains rate, which depends on the investor's modified adjusted gross income (AGI) and taxable income (the current rates are 0%, 15%, 18.8%, and 23.8%).

What constitutes a "qualified" dividend? Most dividends paid by domestic companies and many dividends paid by foreign companies are qualified and taxed at the preferred tax rate. However, distributions paid by real estate investment trusts, master limited partnerships, and other similar "pass-through" entities might not qualify for favored tax status. Also, dividends paid on shares that are not held at least 61 days in the 121-day period surrounding the ex-dividend date are not "qualified" dividends.

How dividends are taxed is very important when considering investments for cash flow. Interest from money markets, bank CDs, and bonds is taxed at ordinary tax rates. That means a person in the top tax bracket pays taxes on interest payments up to 37%. If you compare that to the maximum 23.8 % tax on qualified dividends, the "after-tax" returns are significantly better with dividends.

Say you put $100,000 into a bank CD paying 2% annual interest. You'll receive $2,000 in interest. If you are in the top tax bracket, your after-tax yield (assuming the investment is held outside of a retirement account) is 1.26%. You can calculate that percentage by applying your tax rate of 37% to the $2,000 interest payment, which leaves you with after-tax interest of $1,260 (or an after-tax yield of 1.26%). However, if you invest the same $100,000 in a basket of stocks paying 2% in dividends annually, you'll receive $2,000 in dividends and only lose $300 to taxes (15% of $2,000), for an after-tax yield of 1.7% ($1,700 in after-tax dividends divided by $100,000 investment).

Of course dividend-paying stocks offer greater risk than bank CDs in terms of volatility in investment value, so investors should consider their own risk profiles when choosing income investments. Still, when comparing investments for cash flow, smart investors look at both pre-tax and after-tax yields. After all, it’s not what you make. It's what you keep.

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