Just finished my 2015 tax return, which left our house at the speed of light yesterday. So while still fresh on my mind, thought it might be a good time to talk, at least from the standpoint of taxation, about all of those dividends that have provided yet another year of comfortable retirement living :-)
DW and I hold 66 income securities: individual stocks of C-Corporations, LLCs, MLPs, REITs, Individual bonds, 4 income ETFs, 2 Closed-End Funds, 2 Business Development Companies and a Royalty Trust. These provided just under 300 separate distributions to our taxable brokerage account for 2015. But here's the interesting part: I count 10 different tax forms of distributions.
Note that these are tax character of distributions, not of the sale of assets as would be noted on the 1099-B. Instead, these are distributions as shown on the 1099-DIV, 1099-INT, the Schedule K-1 (partnerships) and could also include the 1099-OID (ugh!). Here is a discussion of each based on the tax treatment of them.
Ordinary Income Distributions:
- Taxable interest shown in Box 1 of the 1099-INT. The source of interest will usually be from individual bonds, bond funds, CDs, Exchange Traded Debt and occasionally preferred stock. US Savings Bond Interest in Box 3 of the 1099-INT is taxable for Federal income tax but generally is not taxable for state income tax.
- Non-Qualified Dividends are not shown separately, but are determined by subtracting qualified dividends in box 1b from Total Ordinary Dividends in box 1a. These are dividends paid from stocks/funds that are taxable but cannot qualify for favorable tax treatment, such as most REIT and Business Development Company (BDC) dividends.
- Short Term Capital Gains distributions, usually from funds (SDY actually distributed STCG for 2015!), are not netted against other capital losses from Schedule D, but are treated as straight ordinary income.
- Net Royalty Trust income as shown in Box 2 of the 1099-MISC is treated as ordinary income, but only after subtracting any depletion allowance on Schedule E.
- Original Issue Discount (OID) interest, shown in Box 1 of the 1099-OID. This is ordinary income that is usually associated with a zero-coupon bond, where the bond is purchased at a discount and then a % of the value of the mature bond is added to the value each year until maturity. This annual assignment is taxed as though received, even though it has not and will not be received until maturity or the discounted bond is sold. Where this could happen in an income portfolio is if it contains a mandatory convertible or maturing (to redemption) preferred stock or ETD that suspends its regular dividend/interest payments.
All ordinary income is combined and will include this dividend income as well as TIRA or other retirement plan withdrawals (that exclude any basis), taxable portion of Social Security, pensions and any earnings from an employer or net income from self-employment. Ordinary income is taxed at the tax table rates as shown from the following table:
Qualified Dividends Distributions:
- This is shown in box 1b of the 1099-DIV. These dividends should be labeled as 'Qualifiable', as to be fully qualified for favorable tax treatment, they must have been taxed as earnings from the company paying them AND the shareholder receiving them must have held the dividend paying stock for at least 60 days during the 120-day period beginning 60 days before the ex-dividend date for common stock dividends, and for preferred stock, the holding period is at least 90 days during the 180-day period beginning 90 days before the stock's ex-dividend date. Qualified Dividends are taxed at the same rate of the net of long-term capital gains (LTCG) (below).
Long-Term Capital Gains Distributions:
- These are distributions from REITs, BDCs, funds (open end, closed-end and ETFs) and K-1s of partnerships. Corporations and LLCs filing as corporations may not distribute realized capital gains but must include them in their income. The total of these distributions is shown in Box 2a of the 1099-DIV and box 9a-c of a Schedule K-1 for partnerships. However, there are multiple types of LTCG distributions that are each taxed at separate rates as shown in the following table:
Box 2b/9c will show the part of LTCGs that represent a recapture of the depreciation expense taken on Real Estate, so this form of distribution is usually limited to REITs. Box 2d/9b shows collectible gains, which for investors will usually represent distributed realized gains from gold/silver/precious metal mutual funds. Box 2c shows Qualifying Small Company Stock capital gains which are rare (I've never seen this distribution) for the individual investor.
Tax Exempt Distributions
These fall into 2 groups: Municipal bond interest and non-dividend distributions or Return of Capital.
- Municipal Bond Interest are not taxed at the Federal tax level, but are taxed at the state level unless the bond was issued by a municipality of that state. These are shown in box 8 of the 1099-INT. If they are issued by a private activity they are usually includable for alternative tax income (Box 9). This form of interest is also used in determining how much of one's Social Security is includable as ordinary income.
- Non-Dividend distributions or a Return of Capital are usually distributed by REITs, BDCs, Closed-End Mutual Funds and MLPs. It is shown in box 3 of the 1099-DIV or box 10 (mutual funds). These are not taxed but must reduce, dollar for dollar, the basis of the distributing security. They represent that part of the distribution that is in excess of the company's earnings and realized capital gains. Once the basis reaches zero, any Non-Dividend Distributions must be treated as LTCG. C-Corporations rarely distribute Return of Capital although it is possible.
How to use this data?
Below is a table I made up (not real) and used in my past article in describing taxation and the income portfolio, that shows how I capture dividends as they come in, and then use this to project the different tax characters and amounts, which will better enable me to calculate quarterly estimated tax payments (note: this is a beginning of year projection for 2015):
As can be seen, the 3 columns to the far right are what I expect the tax character of the dividends to be. But my actual dividends received varied considerably from my projection, due primarily to the multiple tax character of REIT distributions as well as some variation with BDCs and ETFs. I show REITs and BDC dividends as being 100% ordinary income and ETF distributions as 100% qualified dividends, but in fact, only about 65% of the REIT dividends were ordinary income... the rest being a mix of LTCG, Unrecaptured Sec. 1250, Qualified Dividends and ROC. This overestimation of ordinary income meant our quarterly payments were higher than they needed to be. And a good rule of thumb is to never pay in estimated payments to the IRS any more than is absolutely necessary.
My solution to this will be to modify the above Excel SS to show 70% of REIT distributions as ordinary income, and 10% each of qualified dividends, capital gains and ROC. Hopefully, this will reduce our excess payments to the IRS for 2016.
One Final Point:
If you track mutual fund and REIT distributions carefully, you might notice that a REIT's dividend you received and the amount shown on the 1099-DIV for that REIT do not match for the year. This is due to the odd rule that dividend's that are declared at the end of the year by a REIT or mutual fund with the ex-dividend date in, say, December, but the pay date is in January, the dividend will be included in the December year's 1099-DIV, not in the year actually received.
There are advantages to using a pure income approach to providing reliable income during retirement years... and there are disadvantages. One of those disadvantages for those holding investments in taxable accounts is having to track and keep organized the numerous distributions received and their tax character. Of course, one could just download the electronic 1099s into TurboTax and be done with it... while others, myself included, choose to actually track dividends for doing estimated tax and just to ensure they've been received in the amount and at the time expected. But each will manage dividends in ways they are comfortable with.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.