For millions of investors, there's never been a harder time to get the income you need from your portfolio. Even worse, Uncle Sam is lurking just around the corner -- and he wants his cut of your hard-earned money.
Yet as many investors have discovered, some income-producing investments do a better job of letting you protect your money from the tax man. That tax advantage is just one reason why you should include dividend-paying stocks among your investments.
Adding insult to injury
It's already a tough environment for savers. Interest rates on most low-risk investments, such as bank savings accounts and short-term Treasury securities, are close to zero right now. Recently, the interest rate on the shortest one-month Treasury bill actually went negative -- meaning that investors were actually paying for the privilege of tying up their money for several weeks with the federal government.
Sure, some other types of fixed-income investments, such as longer-term Treasuries and corporate bonds, will give you a bit more in the regular payments you receive. But what you get and what you keep are two different things. With bonds, bank interest, and most other fixed-income investments, the IRS will collect tax at your ordinary rate -- as high as 35% right now, and perhaps higher in the near future.
When the federal government takes a third of your already minuscule income away from you come April, it's time to look into alternatives. That's where dividend stocks come in.
Unlike interest, dividends on certain stocks enjoy preferential tax rates under current law. If the payouts you receive count as qualified dividends, then you won't pay your regular tax rate on them. If you're in the 25% tax bracket or higher, then you'll pay a maximum of 15% in tax on your dividends. And if you're in the 10% or 15% bracket, then you'll qualify for a special 0% rate -- meaning you won't pay a cent to Uncle Sam out of your dividend checks.
Now as with just about everything having to do with taxes, there's a catch. Not all dividends qualify for those special rates. In general, U.S. companies and foreign companies whose shares trade in the U.S. have their payouts treated as qualified dividends. In particular, here are some things you have to watch out for:
- Income from real estate investment trusts, such as Simon Property Group (NYSE: SPG ) and Vornado Realty (NYSE: VNO ) , often doesn't count as qualified dividends. Expect to pay your regular rate on that income.
- The same holds true for distributions on royalty trusts like San Juan Basin Royalty Trust (NYSE: SJT ) and BP Prudhoe Bay Royalty Trust (NYSE: BPT ) . Their dividends typically get taxed the same way that ordinary income does.
If your stock meets all those requirements, then your dividends may be qualified. But there are some extra hurdles to jump through.
The qualified dividend rules penalize short-term traders by requiring that shareholders own their shares for at least 60 days during the 121-day period surrounding the stock's ex-dividend date. Essentially, what that means is that you can't buy a stock simply to get the dividend and then sell the stock right after you receive your payment. However, if you're a long-term investor, then buying the shares immediately before a dividend is paid -- or selling them right after a dividend payment -- shouldn't jeopardize its qualified dividend status.
In addition, compared to the piddling income you're getting on other investments right now, dividend yields look extremely attractive. Many well-known large-company stocks offer yields of 5% or more, including DuPont (NYSE: DD ) , Eli Lilly (NYSE: LLY ) , and Philip Morris International (NYSE: PM ) . The extra amount you'll keep in tax savings is just icing on the cake.
Get what you need
Obviously, dividend-paying stocks aren't as safe as Treasury bills or bank CDs. You can lose principal with dividend stocks. But given all the other advantages that dividend stocks have, the additional tax perk they offer makes them nearly irresistible.
So if you don't already own some, consider adding high-quality dividend stocks to your portfolio. The IRS may not be happy about your lower tax bill -- but you will be.