Dividends and taxes

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 $476 to taxes (23.8% of $2,000), for an after-tax yield of 1.5% ($1,524 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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Article copyright 2012 by Charles B. Carlson. Reprinted and adapted from The Little Book of Big Dividends: A Safe Formula for Guaranteed Returns with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

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