Tax Tips for Income Investors

The new lower tax rate on dividends is a boon to investors everywhere, but there are still a few sticky areas to navigate. After all, in the eyes of Uncle Sam, not all dividends are created equal. Depending on your investments and your brokerage account, classifying some of your payouts may require a little extra effort.

In addition, there are investments that -- simply by their nature -- create some extra tax issues of their own. Beyond that, there are new items for 2004 and 2005 that you'll want to be sure you take advantage of -- or watch out for, as the case may be. With that said, Uncle Sam won't wait forever, so let's get to it.

Are you qualified?
In the past, dividend income was just another source of ordinary income, taxed at your normal tax rate, which could be as high as 35%. But thanks to the Jobs & Growth Tax Relief Reconciliation Act of 2003, the maximum tax rate on qualifying dividends has been dropped to 15% for most people. But, ah, that's where they introduced a bit of a challenge, as the $64,000,000 question throughout dividend land has now become: "Am I qualified?"

Qualified dividends are those that are eligible for the reduced 15% tax rate, and typically paid by regular old-fashioned corporations such as Citigroup and Home Depot (NYSE: HD  ) or traditional preferred stocks such as RenaissanceRE Holdings Series C (NYSE: RNRPRC  ) and Merrill Lynch Floating Series 1 (NYSE: MERPRG  ) .

Non-qualified dividends, on the other hand, are not eligible for the reduced rate, so they're taxable as ordinary income at rates up to 35% and are typically paid by entities that don't pay tax at the corporate level. These types of institutions might be real estate investment trusts (REITs) such as Equity Office Properties (NYSE: EOP  ) , master limited partnerships (MLPs) such as Kinder Morgan Energy Partners (NYSE: KMP  ) and Alliance Capital (NYSE: AC  ) , or Trust Preferreds such as Janus Capital PINES (NYSE: SVQ  ) .

The basic instructions for figuring out your qualified- and nonqualified-dividend amounts are included in your IRS Form 1040, but here are a few things for income investors to keep in mind:

In the case of REITs, it's often best to defer taxes on the dividends by placing these securities in a tax-advantaged account such as an IRA. A Roth IRA is even better, as this vehicle allows you to avoid taxes on the income altogether, though you'll be sacrificing a tax deduction in the year you make the contribution.

Though you may be tempted to employ a similar strategy with your MLPs, you might want to resist the urge. Generally speaking, MLPs should not be placed in IRAs for a couple of reasons. First, the income from an MLP is already largely tax-deferred. One of the big differences between the MLP and the REIT -- or other dividend-paying equities -- is that distributions from an MLP are generally 75% to 95% tax-deferred until the unit is sold. That means there's no need to put these investments in an IRA. Think of it as putting tax-free municipal bonds in an IRA -- you can't get more of a benefit than you're already getting.

The second reason to avoid the IRA is that these vehicles are subject to federal income tax on unrelated business taxable income, or UBTI. UBTI is income earned by a tax-exempt entity that doesn't result from tax-exempt activities. As you may have guessed, most income from MLPs is classified as UBTI, and is therefore subject to federal tax even if you hold the units in a tax-deferred account.

With that said, know that your IRA is typically subject to UBTI only if you receive more than $1,000 in UBTI per year (across all IRAs that you hold). Therefore, you would need a comparatively large position in an MLP before you incur a taxable UBTI event.

Finally, in the case of preferreds, traditional preferreds qualify for the 15% rate and are thus OK for taxable accounts, but most of the preferreds issued today are actually trust preferreds (about 80% of them). Because these securities are treated as subordinated debt, the payments they make are considered interest, not dividends, so they're taxed as ordinary income. For that reason, it's usually best to keep investments that pay this type of income -- namely bonds and other debt instruments -- in a tax-advantaged account whenever possible.

To wait or not to wait, that is the question
Overall, the dividend tax relief effort has been quite beneficial for investors, but the whole qualified- and nonqualified-dividend thing has created a bit of a hassle. I imagine our more experienced investors weren't at all surprised last year when they began receiving their first 1099 statements -- forms sent out during tax season by your brokerage firm or bank that detail the breakdown of your dividend and interest payments.

However, they may have been surprised when they began receiving the second, third, or even the fourth revisions of those same statements -- some of which might even have come after April 15, as mine did. The thing is, companies, and therefore brokerage firms, have not yet gotten the hang of classifying their distributions, and that has left them playing catch-up with the new tax laws. Because brokerage firms are required to mail 1099s by the end of January -- before they've adequately classified all the payouts -- this has resulted in the multiple revisions being sent out afterward.

Thus, it may prove worthwhile to do some waiting when it comes to filing your return this year. In the past, I suggested that folks either file early if they anticipated a refund or do so closer to the April 15 deadline if they owed a tax payment. However, because we're likely to experience a similar phenomenon this year in terms of multiple 1099 revisions, I recommend that everyone wait as long as possible before filing their 2004 return.

If you don't, and you then receive a materially revised 1099, you'll likely have to go through the added trouble of filing an amendment to your return. You'll have to file this amendment even if it's just to reclassify gains or dividend income.

Of course, you could simply roll the dice and take your chances on an audit, but I wouldn't recommend it. It's true that audits are less frequent these days, but that's only until it happens to you. It might seem relatively insignificant to Uncle Sam whether or not the money falls into this bucket or that, but as you've probably heard, Uncle IRS is not quite as laid-back.

Indeed, I tend to think of the IRS more as Uncle Sam's big brother, Uncle Bruno, the enforcer with the crooked nose, the limp, and the knuckles that drag the floor. Uncle Bruno is a stickler for details, and somehow I don't think the "It was too much trouble to file an amended return" excuse is going to do it.

The other reason to file the amendment is simply that nine times out of 10 the change is in your favor, and will result in your paying less tax, however modest the actual amount.

Now, I realize that the waiting game is not going to sit well with those expecting a boatload-type refund from Uncle Sam. Though I sympathize, this actually points to a flaw in your tax strategy that you should remedy. Paying too much in withholding tax during the year is akin to giving Uncle Sam a tax-free loan. We don't like that.

Keep that money where it belongs during the year: earning interest in your savings account. You can do that by adjusting your withholding tax to better reflect the amount of your actual tax bill. I used to challenge myself to see how close to breakeven I could get my tax bill at the end of the year. If I fell within $100 either way (i.e., Uncle Sam owed me $100 or I owed him $100), I won a gold-plated watch at retirement. This strategy means less muss, less fuss come tax time. Better still, it means no surprises.

The Foolish bottom line
Well, I'm fresh out of room here, but I hope you've discovered something of use that will save you a few bucks while keeping you in the good graces of both Uncle Sam and Uncle Bruno.

The best thing you can do in the end is keep your eyes open. Though it might sound unlikely, most taxpayers benefit from professional tax advice for the simple reason that they aren't currently taking advantage of the full generosity of Uncle Sam. That's right. It's said that the typical taxpayer leaves an average of $400 on the table because of overlooked deductions. Don't let that be you -- consult a tax professional for your specific situation, particularly if you've got anything more complicated than your basic 1040.

If you'd like some market-beating, dividend-paying stock ideas to go along with your tax tips, consider a trial subscription to Motley Fool Income Investor -- it's yours free. You'll not only find a portfolio of 40 dividend payers that are currently doubling the market's return and boasting a 4.5% yield but also receive our other features designed to provide the ultimate in investor education and save you money in every way possible.

Fool on!

Mathew Emmert can whistle and chew gum at the same time. He's also the editor and chief analyst ofMotley Fool Income Investor. He doesn't own shares in any of the companies mentioned in this article. The Fool is investors writing for investors.


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