Knowing what's a qualified dividend--and what's not--can improve your portfolio's tax efficiency.
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By Christine Benz | 12-20-11 | 06:00 AM | Email Article

Question: I've become a big fan of dividend-paying stocks and like them for my taxable portfolio because of the currently low tax rates. However, I understand that not all dividends are taxed at the low rate. What are the exceptions?

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Answer: You're right--there's a lot to like about dividends. In an uncertain economic environment, a company's ability to show investors the money is an important indication of its financial wherewithal. In a period of ultralow interest rates like the current one, many dividend-paying stocks offer higher yields than bonds as well as the ability to increase those dividends over time. That gives dividend payers a better shot at combating inflation over the long haul than most bonds, whose fixed coupon payments might be gobbled up by inflation.

Last but not least, as you pointed out, the tax treatment on dividends is currently quite low by historical standards. Through the end of 2012, those in the 25% tax bracket and above will pay a 15% tax rate on qualified dividends, while those in the 10% and 15% tax brackets will owe no taxes at all on their qualified dividend payouts. Before their currently low tax treatment went into effect, dividends were taxed at the investor's ordinary income tax rate. (Note that dividend tax treatment is scheduled to return to pre-2003 levels in 2013, which is one reason investors should consider taking maximum advantage of tax-sheltered wrappers such as IRAs and 401(k)s for their dividend payers.)

But what makes a dividend qualified? And more to the point, what types of dividends don't count as qualified?

According to the IRS, a dividend qualifies for the favorable, long-term capital gains treatment if it meets certain criteria. Specifically, the dividend must have been paid by a U.S. corporation, by a foreign corporation that is eligible for benefits under a U.S. tax treaty, or by a corporation whose shares trade on a U.S. exchange. (More on foreign-stock dividends below.) Furthermore, the dividend must have been paid out during the period from 2003 (when the Jobs and Growth Tax Relief Reconciliation Act of 2003 ushered in the era of qualified dividends) through 2012, when the low tax rates on qualified dividends are set to expire. Finally, for dividends to be taxed as capital gains, the stockholder must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. (This article delves into the arcane business of stock dividend dates.)

Those rules give you a lot of room to hold dividend payers within your taxable account and still have those dividends qualify for the favorable dividend tax treatment. Yet as you pointed out, dividends in certain categories won't qualify for the low tax treatment. They include the following.

REITs
REITs are required to pay out 90% of their income to investors, which helps them crank out some of the lushest dividends around. However, the flip side of that payout requirement is that REITs don't pay taxes at the corporate level; instead, REIT shareholders owe taxes, and most of the income they receive is taxed at their ordinary income tax rates. (A portion of a REIT's income may count as qualified, however.) Owing to that tax treatment, investors in the typical real estate fund have paid a tax-cost ratio of 1.8% per year during the past decade, far higher than that in any other equity category.

Certain Foreign Stocks
As noted above, some foreign-stock dividends count as qualified--namely, if the foreign company is eligible for benefits under a U.S. tax treaty or its shares trade as ADRs. However, some don't. As my colleague Patricia Oey points out in this article, Singapore, Taiwan, Malaysia, Hong Kong, Brazil, and Chile are notable examples of countries that do not have tax treaties with the U.S. If you're considering a direct purchase of an individual foreign stock, do your homework on whether its dividends are qualified before stashing it in your taxable account. If you're opting for a dividend-focused foreign-stock fund, your best plan is to hold it within the confines of a tax-sheltered account or seek out a tax-managed foreign-stock fund that can prioritize qualified dividends, such as  Vanguard Tax-Managed International .

Some Equity-Income Funds
If you buy and hold individual stocks, you can do your homework and downplay nonqualified dividend payers. But if you own stock mutual funds focused on dividend payers--such as those with "Equity Income" or "Dividend" in their names--you won't have the same opportunity to pick and choose. Unless a dividend-focused fund is explicitly tax-managed, the manager's only goal is to maximize income and total return. That means it's highly possible the fund will hold companies that kick off nonqualified dividends, and such a fund may even own some bonds, to boot. (The typical equity-income fund owns about 5% in bonds, the income from which is taxed at investors' ordinary income tax rates.) So before you park an equity-income fund in your taxable account, first spend some time looking under the hood.

Securities Held for a Short Time
As noted above, investors need to meet certain holding-period requirements for a stock's dividend to be considered qualified. Thus, if you have a short-term mind-set--or you own a fund whose manager does--you might not receive the preferential tax treatment on your dividends. That's yet another reason to take a long-term view when managing your portfolio.

Certain Types of Preferred Stock
The tax implications of preferred stock dividends depends on the type of preferred with which you're dealing. Traditional preferreds generally qualify for dividend-tax treatment, whereas income from trust preferreds is taxed at an investor's ordinary income tax rate.

Securities mentioned in this article

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Christine Benz has a position in the following securities mentioned above: VTMGX Find out about Morningstar's editorial policies.
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