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Earlier this weekend Morningstar recommended PowerShares' International Dividend Achievers fund (PID) for its focus on quality and low volatility. It likened the fund's portfolio selection strategy to that of Vanguard's Dividend Appreciation fund (VIG), screening stocks which have a history of increasing dividends. Both funds are currently yielding higher than the S&P 500's (SPY) 2.48% and have, as promised, increased their distributions since inception:

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Investors should keep in mind however that not all dividends are created equal. In the U.S. dividends, which meet certain requirements of the Internal Revenue Code are considered "qualified" and taxed at preferential long-term capital gains rates. Non-qualified dividends are taxed at higher ordinary rates. Typically, to be considered qualified a dividend must be paid by a U.S. corporation or one which holds a tax treaty meeting additional criteria; the exception being American Depository Receipts, or non-U.S. companies, which are traded on U.S. markets. Despite these inclusions however, investors should be very wary of a fund's, particularly a foreign fund's, dividend tax treatment. Some funds report this information on their website or prospectus (see Vanguard's), while others can make you wait until tax season for the mail-outs.

Diligently, Morningstar notes PID's distributions are currently treated as qualified dividends. But what if they weren't? The tax difference between ordinary and qualified dividends is well defined, but I believe its implications are not well discussed or understood. If PID's tax status were to abruptly change, what could investors expect in terms of after-tax yield? Are qualified dividends really that important? In order to answer this question we should discuss a few of the basics...

The Taxes

Dividend investors need to be knowledgeable of two taxes, dividend taxes, and capital gains taxes. For the purposes of this discussion we will focus mostly on dividend taxes, noting capital gains taxes will simply be deducted from the final sale of a security. From Wikipedia:

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Note for the majority of earners in the 25% ordinary income bracket, qualified dividends are taxed at a reasonable 15%, while non-qualified dividends are charged a hefty 25%. I speak to income taxes on my blog for more information on tax brackets. Keep in mind either dividend adds to an individual's ordinary income, so if an investor has a salary of $87,850, dividend income will push them into the 28% bracket.

Dividend Re-Investment

When an investor receives a dividend, whether qualified or not, they have the option to either pocket the cash or re-invest it in the security (usually commission free). Most brokerages offer a Dividend Re-Investment Plan (DRIP) to automatically turn dividends back into capital gains. Most dividend taxes are assessed and charged at the end of the year. This means no matter what the tax, investors could take 100% of their distributions and purchase more shares. Theoretically both types of dividend funds can take advantage of the compounding gains from their yield. Note: Some international funds charge a dividend withholding tax, which is taken immediately, this lowers the amount of new shares a DRIP could purchase. See Morningstar for more details.

The Conundrum

So here's where investors might be a bit confused. How can you accurately compare non-qualified dividend paying international funds to their qualified domestic rivals. Assuming two funds, one qualified and the other not, produce the same before-tax yield, we know the qualified fund will always produce the higher after-tax yield.

Some quick math shows us in order to out-pace the tax benefit a non-qualified fund must yield 13.33% higher. So for a qualified fund like the SPY yielding 2.48%, its international rival must yield 2.80%.

However to the non-dividend investor the next best thing is capital appreciation. Since capital gains taxes are assessed on cost basis alone, regardless of dividend status, a non-qualified fund should be able to outperform a qualified one. Since DRIPs re-invest 100% of their pre-tax dividend the capital gains of either strategy will be the same. Thus an alternate question becomes how much more capital gains must a non-qualified fund achieve to outperform its qualified competitor?

Beating Taxes with Capital Gains

The added yield needed to beat qualified divided taxes is easy since the math happens in the same year. If an investor wishes to beat last year's tax with this year's capital gains the math becomes more complicated. Tax calculation can be tricky in itself, tying this to cost-basis as the result of multiple dividend reinvestments can be a nightmare, more-so if that dividend fluctuates. To keep things simple let's assume our rival funds both yield 2.48% pre-tax. Putting this in a table:

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So, if an investor finds an international stock or ETF that he or she loves, beating its domestic rivals' preferential tax-treatment is as easy as beating a fraction of a percent in either yield or return. Keep in mind for funds that yield less than 2.48% the needed capital gains are actually lower, albeit vise-versa for high-yielders. Considering the S&P 500's day-to-day can vary by 0.4% this isn't too hard.

Summary

International markets can offer the promise of higher dividends and higher returns, albeit at the heed of potential confusion. Investors should be wary of how their particular funds are treated under current tax laws and what that can mean for their actual end-of-year yield (especially withholding taxes). Qualified dividends are the extra frosting to U.S. investors choosing to invest in domestic funds, however the actual benefit to that tax treatment adds up to fractions of a percent over non-qualified funds in either dividend yield or capital gain. Should investors know if a particular international fund offers qualified dividends - of course. Should they fret over it - probably not.

Source: Screening International Funds For Qualified Dividends: Is It Worth It?