A Taxing Time

Taxes and Qualified Dividends

By Dale S. Lam, CPA / PFS, CFP®
April, 2014, Excerpt from Quarterly Client Commentary

It’s that time of year again. The one where we spend nights and weekends sorting through our files for the last year to gather all of the necessary information for our tax preparer. Bank statements, mortgage reports, contribution receipts – the list never seems to end. I pride myself on being an organized person, and it still takes many nights and the better part of one to two weekends to get my data together. Tax time is not a fun time, nor is paying taxes.

If you’ve looked closely at your tax statements on your investments, you may have noticed that one of the lines on the annual form 1099 is for “qualified dividends”. The IRS is not very kind to most of us these days, but the taxation of qualified dividends is an excellent, tax efficient means of generating income for investors.

What are Dividends, and what are Qualified Dividends?

Dividends are payments to the owners of businesses (stock holders) from the cash flow of the businesses that they own. Many of the publicly traded companies that we own in our portfolio pay dividends. The management of the company declares the dividend on a per share basis, with the amount varying from company to company.

As an example, let’s assume you own a stock that is currently worth $100.00 per share and the business pays a dividend of $3.00 per share once a year. Assuming the price of the stock stays at $100.00, you are earning a 3% dividend yield on your stock. (The $3 dollar cash that you will receive each year divided by the $100 value in the stock).

What makes a Dividend a Qualified Dividend?

I will spare you the details of the IRS regulations, but in general, most dividends from corporations that you have held for approximately 4 months will be deemed qualified dividends. The nice benefit of a qualified dividend is that the cash payment (dividend) that you receive is treated as a long term capital gain for tax purposes. If we can turn your income into long term capital gains taxation, we have generally hit a home run in terms of tax efficiency. Capital gains are generally taxed at 15% for federal taxes (with a few exceptions).

The Tax Benefit:

Everyone’s tax situation is unique, but many taxpayers are in the 28% to 33% federal tax bracket. For simplicity, let’s just assume that the tax rate is 30%. Earning income as a qualified dividend is considerably more advantageous than earning income as interest (on a CD or a bond), which is ordinary income:

  • $10,000 in qualified dividends, the taxes will be $1,500
  • $10,000 in interest income, the taxes will be $3,000

Your tax burden might be cut in half on the income if you are receiving qualified dividends versus interest income. That’s a huge cash savings and a nice bonus paid to those who invest in stocks.

We certainly have to consider the volatility that we accept when we invest in stocks – it is a roller coaster ride, especially over short periods of time. But, as I have stated time and time again, for long term investors the benefits of having exposure to stocks is quite beneficial to their overall portfolio value. The tax benefit in your annual IRS filing is icing on the cake.

Past performance is not a guarantee of future results.  Any indices referenced are unmanaged and cannot be invested in directly.  See Disclosures.