Dividends and Taxes Dos and Don'ts

Jeremy Glaser: For MorningStar.com, I’m Jeremy Glaser. It’s that time of year
again that investors are worrying about their taxes and a question
of a lot of people’s mind is how dividends are taxed. Here to
discuss it with me is editor of Morning Star Dividend Investor Josh
Peters. Josh thanks for joining me.

Josh Peters: Happy to be here.

Jeremy Glaser: Could you talk a little bit about the different types of dividends and
income that investors could see and how those are going to be
taxed?

Josh Peters: Sure. When you're looking at common equities, they really fall into
three categories. The first is the largest category by far which is
common stocks of traditional C, what we call C corporations.

These corporations themselves pay federal income taxes. If they
pay a dividend because that corporation is paying income tax
before it even has the opportunity to send a dividend to you.
They're what are known as qualified dividends. And for federal
income purposes, the tax rate is capped at 15%.

Then there is another group of very popular higher-yielding stocks,
perhaps not so popular after the crash, but real estate investment
trusts or REITs. These are not eligible for the qualified dividend
treatment because REITs themselves don't pay federal income
taxes.

They're exempt from income taxes as long as they pay out at least
90% of their taxable income to their shareholders, so it's the
shareholders who wind up being taxed on that income. Those
dividends you have to pay tax at your ordinary tax rate whatever
your marginal tax rate is for the particular year.

And then there's another category called master limited
partnerships. And these technically are not corporations at all and
what you get are actually not even called dividends. They're just
called generically cash distributions. In this case, like REITs,
master limited partnerships don't pay federal income taxes.

Instead, what they do is they divvy up their taxable income to
shareholders, actually technically partners of via a schedule K-1
that you receive in the mail, usually sometime in March. And it's
those figures that you consolidate onto your tax return and that is
the basis for what you might have to pay tax on. And if you owe
tax, then it's paid at your marginal tax rate.

Jeremy Glaser: What happens if you own these companies in an IRA or some
other tax-advantaged account?

Josh Peters: Well, with both the qualified dividend payers and the REITs are to
own them in a tax-deferred account is advantageous because you're
not obliged to pay tax on those earnings when you receive them.
You have the opportunity to reinvest the whole thing and increase
your income by owning more shares of a particular company,
particular REITs, whatever the case may be. And you are only
taxed when you make a withdrawal from the account.

Master limited partnerships though it's a little different story. Even
though REITs are allowed to pay dividends into tax-deferred
accounts and they themselves are not paying federal income taxes,
master limited partnerships are taxed in a very, very different way,
a whole different part of the tax code. And the government doesn't
like for those income allocations to be made to tax-exempt entities.
And it isn't just IRAs, its even things like charitable trusts are
really not able to receive that partnership income.

It's not technically illegal but in a worst-case scenario if you
receive more than a certain amount of master limited partnership-
allocated income in an IRA, your IRA would owe tax and have to
file its own tax return. You might have to cut a check from your
IRA to pay tax that you would have owed as a regular taxable
shareholder of a master limited partnership. So it gets very messy.
My recommendation is to just not do it.

Jeremy Glaser: So even if your broker says that you can do it definitely something
to stay away from?

Josh Peters: Anybody who says that you can do it or there's a good way to get
away with it, I would check with a tax advisor first because the
way that master limited partnerships work is that you may be
allocated, in fact, taxable losses have no taxable income even
though you're receiving cash distributions in the first couple of
years you own a partnership because there's all these big
depreciation charges that are front-loaded and you get the benefit
of those up-front.

But later on, as those depreciation deductions become less valuable
that taxable loss that you might be allocated is turning into taxable
income. And then if you should sell, all of the sudden there's a big
catch-up provision where all of the excess depreciation deductions
that you might've had or losses that you might've been allocated
any particular year, those are all trued up to what you actually got
for selling and you could find yourself with a big one-time gain
just from a purely tax book perspective. And that's not the kind of
situation that you want to run into.

I'm not going to say it's illegal, I'm not even going to say, you
know, don't do it ever, ever, ever, but you have to be very, very
careful because the limit, $1,000 a year worth of non-qualifying
income in an IRA is low. Even a relatively modest investment if it
turns out to be successful could bump up against that limit.

Jeremy Glaser: Okay, great. Josh thank you so much for talking with me today.

Josh Peters: Yeah. Sorry this is so complicated but just keep in mind, if you
remember that MLPs really don't belong in IRAs or 401-K plans,
Roth accounts, things like that, you might save yourself some big
headaches down the road.

Jeremy Glaser: Yeah, great. For Morningstar.com, I'm Jeremy Glaser.