To lower your tax rate on income, consider owning investments that pay qualified dividends. Qualified dividends are currently taxed at a maximum rate of 15 percent. The rate drops to 0 percent for lower-income individuals in the 10 percent to 15 percent tax brackets for ordinary income.
What constitutes a “qualified” dividend? Most dividends paid by domestic companies are qualified. And many dividends paid by foreign companies also qualify for the preferred tax rate. However, distributions paid by real estate investment trusts, master limited partnerships, and other similar “pass-through” entities may not qualify for favored tax status. Also, dividends that are 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 on money markets and bank CDs is taxed at ordinary tax rates. So are interest payments on bonds. That means a person in the top tax bracket pays taxes on interest payments up to 35 percent. Compare that to the maximum 15 percent tax on dividends, and the “after-tax” returns are significantly better with dividends.
Say you put $100,000 into a bank CD paying 2 percent 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 1.3 percent. (You arrive at that percentage by applying your tax rate of 35 percent to the $2,000 interest payment, leaving you with after-tax interest of $1,300, for an after-tax yield of 1.3 percent). If you invest the same $100,000 in a basket of stocks paying 2 percent annually in dividends, you’ll receive $2,000 in dividends but only lose $300 to taxes (15 percent of $2,000), for an after-tax yield of 1.7 percent ($1,700 in after-tax dividends divided by $100,000 investment).
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.
A Word of Warning Regarding the Preferred Tax Rate
The preferred tax rate on dividends is in jeopardy. Unless an extension is granted or new rules enacted, the current tax rates on dividends expire at the end of 2012.
Obviously, the tax rate on dividends has huge implications for dividend-hungry investors. Will higher tax rates, if enacted, reduce the appeal of dividend-paying stocks? Will investors dump their dividend-paying stocks once the favored tax rate has expired? Perhaps, although tax rates on dividends cannot be viewed in a vacuum. What happens to the tax rates on capital gains (the current 15 percent maximum tax rate on realized long-term capital gains also expires at the end of 2012) will have a bearing on the relative attractiveness of dividend-paying stocks. And the type of stock-market environment we have after 2012 will impact interest in dividend-paying stocks. Finally, the graying of America will continue to drive a need for cash flow, which should be a plus for dividend-paying stocks.
In short, don’t count out dividend-paying stocks because taxes on dividends may go higher. Plenty of reasons will still exist for investors to seek dividend-paying stocks.