One of the most significant tax increases in recent memory is on the table in the nation’s capitol, and while it remains to be seen if it passes and in what form, the specter of higher capital gains taxes is a point of concern for some wealthy investors.
Market participants are also concerned about the impact that new tax policy could have on dividends and qualified dividend income (QDI), which is currently taxed at favorable rates.
Common equity payouts “are the same as standard federal income tax rates or 10% to 37% for the most recent tax year. By comparison, qualified dividends are taxed as capital gains at rates of 20%, 15%, or 0% depending on the tax bracket. Because of this discrepancy in rate, the difference between ordinary vs. qualified dividends can be substantial when it comes time to pay taxes,” according to Investopedia.
In other words, the tax advantages currently associated with QDI are meaningful and important to investors and have impact on long-term returns.
“Qualified dividends can have a sizable impact on long-term wealth. Suppose an investor’s annual income is $400,000, placing her in the 35% income tax bracket and the 15% long-term capital gains bracket. Let’s say she also parked $100,000 in a dividend-paying fund with a constant yield of 3% each year,” says Morningstar’s Daniel Sotiroff. “If none of the 3% dividend payment is qualified, then the dividend payment is taxed at the investor’s ordinary income tax rate of 35%. At the end of year one, our hypothetical investor keeps $1,950 of the $3,000 pretax dividend payment.”
Examining QDI Regulations
There are some stipulations surrounding QDI that advisors should highlight to clients. Fortunately, these rules don’t require a CPA or expert-level knowledge to comprehend.
For starters, only domestic companies and foreign entities with qualified status are eligible to deliver QDI to investors. Second, investors must hold the dividend-paying security for at least 61 days of a 121-day period. Finally, the dividends cannot be generated from a source that doesn’t have qualified status. Meeting some of these parameters is made easier with exchange traded funds.
“The second criterion has an important yet overlooked wrinkle: It applies to the stocks held by an ETF and the ETF itself. For example, a fund provider may report 100% of an ETF’s dividends as QDI. But investors that have held the ETF for 60 days or less of the specified 120-day window wouldn’t be allowed to claim those dividends as QDI on their tax return,” adds Sotiroff.
Actively managed, the SmartETFs Dividend Builder ETF (DIVS) is an example of an ETF that holds domestic and foreign dividend-paying stocks. It also checks the QDI boxes outlined above.
For more news, information, and strategy, visit the Dividend Channel.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.