Dividends and Taxes (Morningstar)

Dividends and Taxes: Dos and Don'ts

DividendInvestor editor Josh Peters goes over the basics of dividend tax treatment and highlights some potential pitfalls for MLP investors.

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 on a lot of people's mind is how dividends are taxed.

Here to discuss it with me is the editor of Morningstar DividendInvestor, Josh Peters. Josh, thanks for joining me.

Josh Peters: Happy to be here.

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?

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, 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, 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.

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

Peters: Well, with both the qualified dividend payers and the REITs, 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, it's 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've owed as a regular taxable shareholder of a master limited partnership. So it gets very messy. My recommendation is to just not do it.

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

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 a 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.

Glaser: OK, great. Josh, thanks so much for talking with me today.

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.

Highest Yield (from Kiplinger Magazine)

Where to Find Top Yields
From safe municipal bonds to risky closed-end bond funds, just about everything is on sale.

By Jeffrey R. Kosnett

From Kiplinger's Personal Finance magazine, June 2009

It's been an excruciating year for income hogs, their favorite investments obliterated by the recession and the credit crunch. Since September, high-yielding standbys such as real estate investment trusts, master limited partnerships, business-development companies, and oil-and-gas royalty trusts have lost 50% or more. Junk bonds and emerging-markets debt have improved of late, but they've still sustained double-digit losses.
From calamity, however, springs opportunity. Many income securities are now tantalizingly cheap. Moreover, issuers of high-yielding stocks and bonds are sure to benefit from reflation -- the stimulation of global economies through massive government spending and rock-bottom interest rates. Reflation, which implies higher inflation, will hurt low-yielding Treasury bonds, but it should boost the profits of energy producers, real estate operators and highly leveraged companies that need to raise prices to prosper.


The bear market in most income investments has resulted in lower cash payouts, too. With virtually all segments of the real estate sector suffering, dozens of REITs have cut their distributions, and many are paying dividends mainly in stock. Energy trusts have trimmed their disbursements because of low prices for oil, natural gas and other products. Led by financials, hundreds of companies have cut or suspended dividends on their common stock this year.

Credit-market chaos wreaked havoc with the recommendations in our previous "yieldfest" (see Earn 8% or More, July 2008). Our best picks, emerging-markets bond funds such as Fidelity New Markets Income and Pimco Emerging Markets Bond, dropped about 10% over the past year through April 9. Pipeline stocks, such as Kinder Morgan Energy, also held up reasonably well. But we had our share of disasters. For example, First Industrial Realty Trust cratered by nearly 90%, while Genco Shipping & Trading dived 73%.

As the economy begins to improve, the rest of this year and 2010 will be much more rewarding for income seekers. From the safest to the riskiest, we offer our best bets for big cash returns over the coming year (of course, you should keep money that you'll need soon in supersafe instruments, such as money-market funds and bank accounts).

Municipal bonds
The recession is putting pressure on state and local coffers, so why feel good about the prospects for municipal debt? Munis, which rarely default, are yielding far more than comparable Treasury securities. This state of affairs is an anomaly because interest from munis is generally free of federal income taxes. And because munis offer such generous yields, they should hold up far better than Treasuries when the economy and inflation pick up. Still, to be on the safe side, we recommend avoiding tax-free bonds with maturities greater than ten years. At ten years, you can still find 4% to 4.5%, tax-free. That's the equivalent of 6% or so from a taxable bond. Ten-year Treasuries, by contrast, yielded 2.9% in mid April.

Like most other sectors of the bond market, munis suffered last year, but confidence in them has improved. Despite California's budget disaster, the state sold $6.5 billion of general-obligation bonds in March, the third-largest muni issue ever. These A-rated bonds have already gained value. In mid April, a California GO maturing in 2019 with a coupon of 5.5% sold at $1,050 for each $1,000 of face value to yield 4.7% to maturity. For a Californian in the top income-tax bracket, that's like getting 8% from a taxable bond. And for the highest earners living elsewhere, it's the equivalent of 7.2% from a taxable bond.

Some discount brokers, such as Fidelity and Charles Schwab, offer scores of good-quality tax-exempt bonds supported by taxes or the revenues from water bills, highway tolls and the like. In mid April, a representative ten-year, double-A-rated, noncallable water-system bond, such as an Orlando utilities commission issue, yielded 4.8% to maturity. If you prefer a fund, Baird Intermediate Muni (symbol BMBSX) was the top medium-maturity muni fund in both 2007 and 2008. Other standouts include Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25, and Schwab Tax-Free (SWNTX).

Ironclad mortgages
Toxic mortgages are the match that lit the financial firestorm, but you can't blame government-guaranteed loans from the Veterans Administration or the Federal Housing Administration. The VA foreclosure rate is 1.7%, compared with 13.7% for adjustable-rate subprime loans.

The best way to own these loans is through a Ginnie Mae fund. Backed by the full faith and credit of the federal government, the Government National Mortgage Association guarantees packages of FHA and VA debt bundled together by private lending institutions. From the perspective of timely repayment of principal and interest, Ginnie Maes are just as safe as Treasuries but deliver significantly more yield. And although mortgage rates have fallen, many GNMA funds still own lots of older, higher-paying loans. For example, almost 40% of the loans in Vanguard GNMA (VFIIX) carry yields of more than 6%.

Vanguard's fund and other low-cost Ginnie Mae funds, such as Payden GNMA (PYGNX) and Fidelity Ginnie Mae (FGMNX), still yield about 5%. GNMA yields should decline by half a percentage point by the end of 2009 because lower mortgage rates encourage more borrowers to refinance. But these securities will generate higher cash flows after mortgage rates, like other long-term rates, start to turn up later this year.

Bank-loan funds
These funds hold slices of adjustable-rate loans and lines of credit that banks extend to companies with junk credit ratings of single-B or double-B. Adviser Mark Gleason, of Wescap Management Group, in Burbank, Cal., aptly calls a bank-loan fund "a hybrid between a junk-bond fund and a money-market fund." The bank funds currently yield 4.5% to 6%, which is far short of junk's double-digit yields. But their loans are safer because their terms are short, their interest rates float with changes in short-term rates, and they are ahead of bonds on the repayment pecking order should the borrower default. However, like stocks and junk bonds, bank loans gain value prior to or in the early stages of an economic recovery. Year-to-date through April 9, bank-loan funds returned an average of 11.1%, tops among bond-fund categories.

By contrast, in the three-month period that ended last November, the average bank-loan fund lost 29% as the credit crunch and selling by hedge funds slashed the value of bank debt. But defaults didn't get out of hand, so funds such as Fidelity Floating-Rate High Income (FFRHX) and the closed-end PIMCO Floating Rate Strategy (PFN) kept up decent monthly distributions even as their share prices dropped. These payouts are sliding because short-term interest rates are near zero, but bank-loan funds still offer better yields than short-term-bond funds. Gleason sees annual total returns of 9% to 11% through 2012.

Triple-B corporate bonds
This is the sweet spot in taxable bonds. In 2008, the gap between yields of a basket of triple-B-rated bonds and Treasuries exploded from two percentage points to six and a half. In mid April, the gap was almost five points, which is attractive when you consider that bonds rated triple-B are still considered investment-grade. Moreover, the category harbors a bunch of recession-hit companies that traditionally have carried single-A ratings. Today's triple-B roster includes Altria, Burlington Northern, Johnson Controls, Kraft Foods, Black & Decker, Sunoco and XTO Energy. All will thrive in better times.

For safety's sake, choose bonds from across several industries. Noncallable bonds are nice, but as rates rise, you won't see many redeemed early anyway. In mid April, an Altria bond maturing in 2018 and carrying a 9.7% interest coupon was priced to yield 8% to maturity. Bank and insurance bonds offer high yields because financial issuers are riskier than industrials, despite government efforts to keep them afloat without nationalizing them.

Pipelines
Energy prices will rise as industry expands and people drive more. So you can buy energy-income investments at sale prices and hold on for what should be higher future dividends. If you think oil prices will zoom or if you just want to hedge against inflation, buy BP Prudhoe Bay (BPT), a royalty trust that passes through cash from the sale of crude oil. BPT crashed last summer and has cut dividends two times since, but it's back to $68 from a low of $50, and it yields 6%.



If you don't want to gamble on energy prices, pipelines and storage facilities are the ticket. Their dividends depend on the amount, not the price, of the products that move through these systems. Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP) and Magellan Midstream Partners (MMP) all have long histories of delivering dividends reliably, and they currently yield from 8.8% to 9.2%. Because these firms are set up as master limited partnerships, they'll send you a Form K-1 at tax time, rather than a Form 1099, and that could mean extra work filling out your returns.

Preferred stocks
It wasn't just common stocks that went on a tear after bottoming on March 9. Preferred stocks, which act a lot more like bonds than stocks, also rallied strongly. From March 9 through April 9, iShares U.S. Preferred Stock Index (PFF), an exchange-traded fund, rocketed 66%, although it remains 45% below its 12-month high. Tom Taylor, of Thoma Capital Management, in Towson, Md., notes that a preferred stock from Bank of America (BAC.H) yields 14% to maturity in 2013 and cannot be called or exchanged. The stock surged from $5 to $15 between February 19 and April 9. But its face value is $25, so it can still go higher.

Preferreds, despite the reassuring name, are not risk-free. Issuers can cut or suspend preferred dividends, as a handful of REITs have done during the financial crisis. And if a company files for bankruptcy, bondholders take precedence over preferred investors. You can spread your risk with a fund that focuses on preferreds. John Hancock Preferred Income (HPI), a closed-end fund, owns far fewer financials than does the iShares ETF. At its April 9 close of $12, the fund traded at a 4% premium to its net asset value and yielded 15%. It would be better if the fund traded at a discount to NAV, but the modest premium is acceptable.

Junk corporate bonds
Let's face it: Recessions are not good for junk bonds and their issuers. Junk-rated companies are young, troubled, highly leveraged, or some combination of the three. So it's not surprising that they suffer when sales sink and questions about their ability to service their debt mount.

But the current recession has been less discriminating than most. Previous junk-bond routs involved "bad companies with bad balance sheets," says Mark Durbiano, a manager at Federated Investors who has seen the good, the bad and the ugly during a 25-year career investing in high-yield bonds. This time, he says, investors pummeled bonds of essentially good companies, such as First Data and SunGard, whose high debt loads earn them junk ratings. The average junk bond recently yielded 18%, a near-record 15 percentage points more than Treasury bonds.

But now, with signs that the economy is thawing and bargain hunters nibbling, things are starting to look up. The average junk-bond fund, which lost 26% last year, returned 6% in 2009 through April 9. The indexes -- but not the whole sector -- will take a temporary hit if General Motors, a huge junk-bond issuer, defaults. But the three primary junk ETFs -- SPDR Barclays Capital (JNK), iShares iBoxx $ High Yield (HYG) and PowerShares High Yield (PHB) -- hold few or no GM bonds (but plenty of health and technology issues). Each yields 10% or higher.

Wild closed-ends
We've saved our lottery tickets for last. Scott Leonard, of Trovena, an advisory firm in Redondo Beach, Cal., seeks out income-oriented closed-end funds in struggling but improving sectors that are leveraged, selling at big discounts to NAV. Dozens qualify. Consider, for example, Cohen & Steers REIT and Utility Income (RTU). At its April 9 close of $5.28, the fund sold at a whopping 25% discount to NAV and yielded a similarly massive 26%. Or look at BlackRock California Municipal Income Trust II (BCL). At a price of $10.18, it traded at a 19% discount to NAV and yielded 6% tax-free. Don't put more than 5% of your income assets into these kinds of funds because when they're bad, they're really, really bad.



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