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Paying taxes once on your investments can be painful enough. But many people don't realize that dividend investments can double the IRS's chances to reach into your wallet -- unless you take advantage of a clever, simple strategy to block the tax man.

Double trouble
Imagine that you own shares of stock in Meteorite Insurance (Ticker: HEDSUP). You and the other shareholders actually own the company, which thus takes in revenue and wrings out profit on your behalf. Before the company arrives at your profit, though, it pays its corporate taxes. So Meteorite Insurance pie has already paid taxes on your slice of the profit pie. Got that?

Meanwhile, as a shareholder in Meteorite Insurance, you receive a quarterly dividend. And each year, when you prepare your tax return, you have to include your dividend income -- so that you can be taxed on it. That's the second tax hit.

The good, the bad, and the taxable
For the moment, that tax hit mercifully tops out at 15% for most of us, thanks to a set of 2003 tax cuts. But those cuts are due to expire at the end of the year. If they're not extended (which they might be), dividends will go back to being taxed at your ordinary tax rate, which could be as high as 35%.

Check out how much you'd owe in a single year with each tax rate, if you had $10,000 invested in each of the following companies:


Recent Yield

Ann. Dividend on $10K Investment

15% Tax on Dividend

35% Tax on Dividend

Qwest (NYSE: Q  )





Nokia (NYSE: NOK  )





NYSE Euronext (NYSE: NYX  )





Duke Energy (NYSE: DUK  )





DuPont (NYSE: DD  )





Kraft (NYSE: KFT  )





GlaxoSmithKline (NYSE: GSK  )










Data: Yahoo! Finance.

Don't give up on dividends
Even though dividends get taxed twice, that doesn't mean you should steer clear of stocks that offer payouts. In fact, if you play your cards right, you can reduce those taxes to zero!

Park your healthy dividend payers in your Roth IRA. If you play by the rules, you should be able to withdraw your money -- capital appreciation, dividends, and all -- completely tax-free. And even in a regular IRA, you'll be able to defer paying taxes on your dividend payments when you receive them.

Getting double-taxed on your investments isn't any fun. Hopefully, the current tax break on dividends will get extended in some form. Otherwise, investors might be in for a shock when tax time 2012 rolls around.

Dividends are valuable in more ways than one. Chuck Saletta can show you how ordinary investors trounced the lost decade.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Nokia is a Motley Fool Inside Value recommendation. NYSE Euronext is a Motley Fool Rule Breakers pick. Duke Energy is a Motley Fool Income Investor recommendation. The Fool owns shares of GlaxoSmithKline. Try any of our investing newsletters free for 30 days. The Motley Fool is Fools writing for Fools.

Read/Post Comments (1) | Recommend This Article (7)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 26, 2010, at 2:36 PM, DaveNNeal wrote:

    good article, as usual selena, but if you don't want to pay any tax at all on your dividends, add some REITs to your Roth! a Real Estate Investment Trust does not pay tax at the corp. level, must pay out 90% of profits as dividends, and when placed in a Roth, generates no tax to the recepient. that's what i call "tax efficient," even to a libertarian like me! add some diversification, using commercial REITs, appartment REITs, and even some timber REITs and you have portfolio power. there are often beaten down REITs that have great gain potentials as well, such as MPW which closed at $2.91 on 3/9/09 and is trading for almost $10 today. i limit my US REIT exposure to 15% of my overall portfolio, however, plus another 10% in foreign real estate.



    disclosure, i own MPW (purchased at $3.18) and many other REITs and REIT ETFs, in my and my wife's Roth IRAs.

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