I love dividend paying stocks. They provide steady income, offer dividend increases that keep pace with inflation, afford the opportunity for stock price appreciation and have tax advantages when compared to interest income, to a degree.
There are 4 flavors of income taxes on dividends: Qualified, Non-Qualified, K-1 and Foreign Tax Withheld. Each of these dividend types have different income tax rates. We only care about after-tax income so how do you know which stocks to buy and what yields are better than others? It’s a simple but complex answer.
Qualified dividends are taxed at either 0%, 15% or 20%, not a progressive tax, like income taxes, but a flat tax based on income.
Non-Qualified dividends are taxed as ordinary income. So, your taxes paid are based (most likely) on your top tax bracket if you have salary income.
K-1 income from Master Limited Partnerships have complex rules and vary by company. Your cash receipt (dividend) may contain a return of capital (no tax) and other categories so it’s more difficult to compare tax rates, and after-tax income.
Foreign Tax Withheld means that the dividends you receive may have foreign taxes withheld as payments are made so you receive a “net” amount. You may or may not have these taxes paid to foreign jurisdictions count toward your US taxes paid. It depends on the country and tax treaties with the US. Plus, your tax preparer needs to fill out more forms to claim these taxes paid to foreign jurisdictions against your US ax obligation. See what I mean?
So, the high yield on Canadian Imperial Bank (“CM”), a Canadian Bank, looks great at 5.79%, but how much of that will you get to keep?
The simplest strategy is to focus on Qualified and Non-Qualified dividends. My rule-of-thumb is to seek non-Qualified yields 50 bps higher than a Qualified dividend yield to make the after-tax yield about the same.
But what about Interest from a money market account?
Today’s yields on money markets and Treasuries are pretty good: 5.00% - 5.38%. The interest earned on these is taxed as ordinary income. So how would you compare the qualified dividend yield with a money market rate?
My rule-of-thumb is I want a qualified dividend yield within 80 bps of the money market rate. I’m willing to take a lower dividend yield (by .80%) because of the tax differential and upside from the dividend increases and stock prince appreciation. Dividend increases and stock price appreciation are NOT guaranteed, and so involve risk. Keep that in mind.
A married couple, filing jointly with $750,000 in income would have an effective tax rate of about 26.84% (not adjusted for deductions, etc.). That same couple would pay 20% taxes on their dividends. The more you make the greater the differential between dividend taxes and “effective” ordinary income tax rates. Perhaps that’s why the wealthy love dividends.
Here are the tax tables for this year. Start planning your tax strategy now so you maximize your after-tax income for this year.
Comments welcome.
Hugh
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