Dividend Taxes and Investment Returns

Dividends can be a significant contributor to your investment income. However, when it comes to taxes, not all dividends are created equal. While taxes generally should not be the primary consideration when choosing where to put your money, if you are considering two otherwise comparable investments, the tax treatment of dividends could be an important factor in making your final decision. Here is what you need to know about the tax treatment of a variety of different dividends.

Qualified Dividends

According the IRS, qualified dividends are "ordinary dividends that meet the requirements to be taxed as net capital gains." For dividends on a common stock you own to qualify, you must, among other things, hold the shares for at least 61 days of the 120-day period beginning 60 days before the stock trades ex-dividend (or without the dividend). The ex-dividend date is important because you must own the shares before this date date to receive the dividend. Currently, federal income tax rates on qualified dividends are quite favorable, since they are 0% if you are in the 10% or 15% tax brackets and 15% above that.

Ordinary Dividends

Ordinary dividends are taxed at your ordinary income tax rate.

REIT Dividends

For tax purposes, dividends paid by real estate investment trusts or REITS are treated as ordinary income no matter how long you have held the REIT's stock. REITs are required to pass through to shareholders at least 90% of their pretax income. The rationale for characterizing REIT payouts as ordinary dividends is that the corporation pays no income tax on this income before distributing it to shareholders.

Master Limited Partnership Dividends

Master limited partnerships make payments to shareholders that, on the surface, appear to be dividends. In fact, as the designation "master limited partnership" suggests, these entities are partnerships and, as such, they distribute their income to their partners (or shareholders). This payout (or most of it) is categorized as a return of capital rather than a dividend. For tax purposes, this means that no tax is due on the distribution at the time it is paid. Instead, it reduces a shareholder's cost basis in the stock of the master limited partnership. Taxes are paid when the stock in the master limited partnership is sold.

Stock Dividends

A stock dividend is a dividend paid in stock rather than cash. Unless a stock dividend includes a cash dividend option, it generally does not result in a taxable event. When a company pays a stock dividend, it is simply issuing more shares without raising additional equity or directly increasing the market capitalization of the company. As a result, all other things being equal, the stock's price per share will simply adjust to reflect the stock dividend. For example, consider a company with a $20 share price that has 10 million shares outstanding and a market capitalization of $200 million. If this company pays a 10% stock dividend, its share count will increase to 11 million shares, but its market capitalization will still be $200 million since no new equity capital was raised. Therefore, its share price will decline to $18.18 per share to reflect the increase in the number of shares.

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