Practical analysis for investment professionals
22 August 2016

Don’t Forget Taxes When Comparing Dividend Yields

Don’t Forget Taxes When Looking at Dividends

Investors have been pouring money into dividend-centric investment strategies lately.

Year-to-date flows into dividend-focused exchange-traded products reached $7.4 billion in June 2016, more than seven times the 2015 total, according to Richard Turnill, BlackRock’s global chief investment strategist.

This “buy yield first, ask questions later” mentality has sent the prices of many popular dividend plays, such as real estate investment trusts (REITs) and utilities, soaring.


REITs Index and Utilities Index Five-Year Price Performance


As prices rise and yields fall, are certain dividend income strategies no longer attractive? There is no simple answer.

Investors are faced with numerous uncertainties when debating the merits of dividend-paying stocks. Every company is different in its ability to pay or increase dividends, and no one knows for certain what the future holds for competing bond yields. Even shares of high-quality companies are vulnerable to headline risk and temporary price declines. Investment professionals are more likely to add value by helping yield-starved clients focus on issues that are a bit more certain, like taxes. To this point, a recent poll by CFA Institute suggests that focusing on tax efficiency is one of the top ways for active investment managers to enhance client portfolios.

In their overzealous efforts to chase yield, investors often fail to consider the tax implications involved in owning dividend-focused investment products. The tricky thing about dividend income is that not all of it is taxed the same way.

Non-qualified and qualified dividends each have a different tax rate. Non-qualified dividends are taxed as ordinary income at a rate of up to 39.6%, while qualified dividends are taxed at a lower rate of up to 20%. The table below illustrates the current federal tax rates on non-qualified and qualified dividend income.


Federal Income Tax Rate vs. Federal Qualifed Tax Rate

Note: There may be additional taxes on dividend income that are not included in this table, such as an additional 3.8% net investment income tax and state and local income taxes.


Investors can learn two key points from this. First, income taxes could cut a juicy dividend payment almost in half; and second, those investors in the higher income tax brackets are subject to a spread of about 20% between the federal tax rate on non-qualified vs. qualified dividend income. With a dividend payment of US$5,000, this spread would result in a $1,000 difference in the amount of after-tax income an investor would receive. This is significant if the dividend is expected to be the main contributor to an investment’s total return.

Allocating high dividend paying investments into tax deferred accounts, such as an IRA, helps to negate these tax issues. If this is not an option, below are a few things tax-sensitive investors should consider when gauging which type of dividend income an investment strategy distributes.

Current Holdings and Past Distributions

A list of the investment strategy’s current holdings is the most obvious place to start. Most US listed stocks pay qualified dividends, although there are a few that may not. For example, dividend income strategies that are heavily invested in real estate investment trusts (REITs), business development companies (BDCs), certain foreign stocks, trust-preferred stocks, or preferred stocks issued by REITs distribute at least some non-qualified dividend income.

The tax classification of a strategy’s past dividend distributions is something else to consider. For example, iShares has a table that summarizes the percentage of calendar year dividends paid by their exchange-traded funds (ETFs), which represent qualified dividend income.

Strategy Implementation

The way a strategy is implemented could affect how dividend distributions are taxed. Many investors are unaware that they must meet special IRS holding period requirements in order for dividend income to receive qualified tax treatment. A common stock must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. In the case of preferred stock, investors must have held the stock more than 90 days during the 181-day period beginning 90 days before the ex-dividend date, if the dividends are due to periods totaling more than 366 days. The days in which an investor’s risk of loss on a stock is diminished do not count toward these required holding periods. So strategies with very high turnover, or ones that directly hedge stock positions such as buying protective puts, might end up negating the tax benefits of otherwise qualified dividend income.

Conclusion

Seth Klarman’s 1992 Forbes article, “Don’t Be a Yield Pig,” is still very relevant today. Many stable dividend-paying stocks trade at historically lofty valuations and produce income taxed at unfavorably high rates. This type of environment is ripe for investment advisers to add value by customizing an investment strategy based on each client’s investment objectives and constraints.

By working in conjunction with a tax professional, advisers can help clients sort through the numerous risks and tax implications involved in owning dividend-centric investment products.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/retrorocket

About the Author(s)
David Allison, CFA, CIPM

David L. Allison, CFA, CIPM, is vice president and founding partner at Allison Investment Management, LLC. He has formal training in investment analysis, portfolio management, and investment performance measuring techniques. Allison has extensive experience managing investment portfolios for high net-worth investors. He is an active member of CFA Institute, the CIPM Association, and the CFA Society of South Carolina, where he is a former president and currently serves on the board of directors. Allison holds of degree in finance from the University of North Carolina at Wilmington.

3 thoughts on “Don’t Forget Taxes When Comparing Dividend Yields”

  1. Marcus says:

    EXCELLENT story!

    There is quite a bit of literature out about where to hold FI/Munis in taxable or IRA accounts, but this deepens the conversation that an advisor can have with clients

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