To lower your tax rate on income, consider owning investments that pay qualified dividends. These dividends are taxable federally at the capital gains rate, which depends on the investor’s modified adjusted gross income (AGI) and taxable income (the rates are 0%, 15%, 18.8%, and 23.8% for 2014).
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.