(By Christine Benz) Dividend-paying stocks have enjoyed a renaissance during the past several years. Following the late 1990s and early 2000s--an era marked by the squandering of shareholder assets on misguided acquisitions and inflated pay packages--investors have gone into "show me the money" mode. The high-profile blowups of many financial stocks notwithstanding, dividend payers generally outperformed nondividend payers during the financial crisis.
Further burnishing dividend payers' appeal is the currently benign tax treatment of dividends--those in the 25% tax brackets and above pay taxes at a 15% rate on qualified dividends, while those in the 10% and 15% tax brackets pay no taxes at all on such dividends.
That's a big attraction, but investors need to mind their p's and q's before embracing dividend payers for their taxable accounts. Here are some tips and traps.
Do:Understand the Difference Between Qualified and Nonqualified Dividends
You often hear that the dividend tax rate is either 15% or 0%, depending on your tax bracket. But if it's not the right kind of dividend, you could actually owe ordinary income tax on your dividends--giving your payout a haircut of as much as 35%, depending on your tax bracket. That's because the Internal Revenue Service separates dividends into qualified and nonqualified bins. One big category of nonqualified dividends are those that REITs kick off; while their yields might be lush relative to the income you receive from other stocks, you'll owe ordinary income tax on that income. (Owing to that tax treatment, investors in the typical real estate fund have paid a tax-cost ratio of 1.9% per year during the past decade, far higher than any other equity category.)
Foreign-stock dividends will not necessarily qualify for the low tax treatment, either. Unless a foreign-stock dividend counts as qualified, which usually means that the company is eligible for benefits under a U.S. tax treaty or trades as an ADR, you'll owe ordinary income tax on any dividends received. That's why it pays to do your homework before reflexively assuming that all dividends are created equally from the standpoint of taxation.
Watch Out for Income-Focused Funds
If you buy and hold individual stocks, you can do your homework and downplay nonqualified dividend payers. But if you own stock mutual funds focused on dividend payers--such as those with "Equity Income" or "Dividend" in their names--you won't have the same opportunity to pick and choose. Unless a dividend-focused fund is explicitly tax-managed, the manager's only goal is to maximize income and total return.
That means it's highly possible--even likely--the fund will hold companies that kick off nonqualified dividends, and such a fund may even own some bonds, to boot.