With April 15 looming ever closer, investors are forced to look to the days when the taxman will inevitably cometh. Overall, due to some generous changes to the tax code this past year, this tax season should be brighter than any in recent memory. However, depending on what securities you hold and even what type of brokerage account you use, a few nasty surprises could be lurking in the depths of your portfolio -- especially when it comes to dividends.
As the editor of the Fool's dividend-oriented newsletter, Motley Fool Income Investor, I find investing for income to be extremely gratifying. But there are a number of details that come along with the strategy that investors must take into account. Otherwise, they could miss out on some of the recent tax cuts.
Skip to in-lieu
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.
While this is excellent news for investors, the new tax rate on dividends -- which makes it equal to the long-term capital gains rate -- created a little issue between individual investors and their brokerage firms. If, like numerous investors these days, you have a margin account, and your broker decides to lend your shares -- which they can do without your permission -- the dividend would have to be paid to the person who borrowed the shares.
Now, you're still entitled to a payment in the amount of the dividend as well, so your broker pays you the equivalent dividend amount, which is referred to as an in-lieu payment.
Why should you care? The IRS will treat those in-lieu payments as ordinary income, meaning you'll have to pay your ordinary personal income tax rate on them. So, in effect, just because your brokerage firm decided to lend your shares, you lost your 15% dividend tax rate.
How will you know if your brokerage firm gave you the old dividend switcharoo? When you receive your 1099 Dividend form from your broker, look not only at the amount reported as dividends, but watch for "in-lieu" or "substitute" payments.
There is a movement afoot that would require an account holder's explicit agreement in order for the broker-dealer to lend a client's securities. However, as you might expect, this is not gaining much traction with large broker-dealers such as Citigroup's (NYSE:C) Salomon Smith Barney unit, Merrill Lynch (NYSE:MER), or Wachovia (NYSE:WB). At this point, the only safeguard is keeping the securities you don't want your broker to lend in a cash account instead of a margin account.
And the hits just keep on comin'
You should also be aware that real estate investment trusts (REITs) and master limited partnerships (MLPs) don't pay taxes at the corporate level. Therefore, they are ineligible for the reduced tax rate on dividends.
In the case of REITs, it's often best to defer taxes on these dividends by placing these securities in a tax-advantaged account such as an IRA. However, when you withdraw these funds, you'll have to pay taxes on them at ordinary income-tax rates, which, again, will likely be higher than 15%.
So, whether this option will be beneficial depends on your time frame. Will you save enough on the tax-deferral to offset the increased taxes that you'll pay upon withdrawal? If you're less than five years away from retirement, probably not. Of course, a Roth IRA can be an excellent option for your income-producing investments, since you can avoid taxes on your dividends and interest payments entirely (though you won't get a tax deduction in the year you make the contribution).
Picky partnerships
Though you may be tempted to employ a similar strategy with your MLPs, resist the urge. Generally speaking, MLPs should not be placed in IRAs for a couple of reasons. First, IRAs 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.
The other reason you don't want these puppies in a tax-deferred account is that the income from an MLP is already 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 being similar to putting tax-free municipal bonds in an IRA -- you can't get more of a benefit than you're already getting.
Gaining trust
The last hurdle income investors may find themselves facing this tax season relates to preferred stock. Though it's true that dividends on traditional preferreds are eligible for the new 15% tax rate, 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 prudent.
The Foolish bottom line
Despite the trials and tribulations that I've detailed here, a dividend-oriented investment strategy can produce powerful results. Even without the reduced dividend tax rate, many of these investment classes offer yields that are far superior to alternative investments.
Fool on!
Mathew Emmert likes his dividend payments over easy with a side of bacon. He doesn't own any of the securities mentioned in this article, but he is the editor of Motley Fool Income Investor. Consider a free trial with no strings attached. The Fool has a disclosure policy.
