Know The Tax Implications Before You Invest In Dividend ETFs

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Includes: AMLP, EFA, MLPY, VWO, ZMLP
by: Shilpa Khire

Summary

Qualified dividend Vs Non qualified dividend tax could make a significant difference to your net income.

Know the ETFs which do not qualify for distributing qualified dividends.

Calculate your net return after taxes before making investment decisions.

In the recent past, dividend yielding instruments have become very popular amongst investors, be it stocks, mutual funds or ETFs. Dividend instruments provide a steady stream of income every year along with capital appreciation in the long run.

Often times, investors merely look at the dividend history of a particular ETF as the only yard stick for dividend investing. However, in order to calculate the net income which you will receive as investors, you need to be aware of the tax implications of your investment as well.

The dividend distributed by any ETF, mutual fund or shares is either classified as qualified dividend or non qualified dividend. Investors are either unaware of these terms, or do not know what exactly do they mean or are completely surprised when a dividend received is reported on Form 1099 as interest.

Classification of dividend in each of these categories has a significant bearing on the tax liability.

Qualified Dividend Vs. Non qualified Dividend

So what is the difference between qualified and non qualified dividend?

Qualified dividend is a type of dividend which qualifies for a favorable or a lower tax treatment. Non qualified dividend on the other hand does not qualify for a lower tax preference and is therefore taxed at an individual's normal tax rate.

What is the rate at which qualified dividend is taxed?

The rate at which qualified dividend is taxed depends on the rate at which an individual is paying his ordinary income tax. The table below will explain the qualified dividend tax rate:

The rate at which an individual is paying his ordinary income tax rate

His qualified dividend will be taxed at

10%

0%

15%

0%

25%

15%

28%

15%

33%

15%

35%

15%

39.6%

20%

As you can see here, there is a significant amount of difference between the ordinary tax rate (which is also the same for non qualified dividends) and qualified dividend tax rate. So, it is always better to choose the funds which are eligible for the favorable treatment.

Dividend ETFs may not be good for taxpayers paying taxes in higher tax brackets

I would like to bring up an important point here that people who are in the higher ordinary tax brackets may not significantly benefit from dividend ETFs. Even if they receive a qualified dividend, that would still be taxable at 20%, and if the dividend is non qualified, then the tax rate would be a whopping 39.6%. They can think of switching over to a capital appreciation ETF when they have higher income and then switch over to a dividend ETF when their normal income reduces or at the time of retirement.

Which ETFs are eligible to distribute qualified dividends?

In order to distribute qualified dividends, the following two conditions must be satisfied:

  1. Dividends must be paid by an American company or a qualifying foreign company and
  2. To receive a qualified dividend, an investor must hold an ETF for more than 60 days during the 121 days starting 60 days before the ex-dividend period. If you hold the ETF for less than 60 days, the dividend will be taxed as ordinary income.

Generally if you own an ETF that owns stocks of U.S. companies, those dividends paid are most likely qualified.

Having said the above statement, there are some very common investments that are widely held, that do not pay qualified dividends in many cases. Those include the following:

1. Dividend payment by bond ETFs - Bond ETFs make regular (usually monthly) payments to shareholders. Though often called as "dividends", these interest payments are not considered "qualified" by the IRS. They are not eligible for a favorable tax treatment and are taxed as ordinary income.

2. Real Estate Investment Trust (REIT) ETFs - While some dividend distributed by the REIT may be classified for the preferential tax treatment, most of it will be non qualified dividend and taxed at the normal tax rate.

3. Taxation of Master Limited Partnership (MLP) ETFs - A lot of ETFs tracking the Master Limited Partnership market are structured as open-ended funds, but classified by the IRS as C corporations for taxation purposes. Therefore they are also taxed at the higher ordinary tax rate.

Recently, MLPs have also been looked upon for strong dividend yields in the range of 5% to 8%. Now, if you only invest in MLPs for a high dividend income and factor in the tax rate, you will probably lose all the extra income earned right there.

If you are unaware of the tax implications, it is very likely to be attracted to such high dividend yield ETFs. But make sure you understand the nature of income received before you invest.

4. Dividends from Emerging Market ETFs - A very common ETF, gaining more than ever popularity are Emerging Market ETFs. But please remember that Emerging market ETFs may not always be tax efficient. Since they invest in foreign companies, some portion of the dividends is likely to be taxed as qualified and some will be non qualified dividend.

The fund may not be able to let the investors know how much would qualify as qualified and how much would be non qualified dividend in advance. However, you can check the previous year dividend distribution and work with it. Generally, whenever the funds entire distribution can be classified as a "qualified dividend", the fund would explicitly make such a statement and let the investors know.

Let us take the example of two high dividend yield ETFs and see their effect net of taxes in the hands of the investor.

  1. Vanguard FTSE Emerging Market ETF (NYSEARCA:VWO) and
  2. iShares MSCI EAFE ETF (NYSEARCA:EFA)

The dividend yield for these ETFs in 2015 was as follows :

 

Sr. No.

ETF Ticker

Dividend Yield

1.

VWO

3.02%

2.

EFA

2.75%

Let us assume for the sake of simplicity that the market price of the investment in VWO is $50,000 and that in EFA is $55,000. So, the dividend distributed will be

Sr. No.

ETF Ticker

Market Value of Investment

Dividend Yield

Dividend Received

1.

VWO

$50,000

3.02%

$1,510

2.

EFA

$55,000

2.75%

$1,512

So for the sake of simplicity,we are assuming that the investor is receiving a dividend of $1,510 in both the ETFs. Now, out of the declared dividend, in the year 2015, only 5% dividend was qualified for VWO and 95% was non qualified. However, 100% dividend was qualified for EFA.

Let us assume that the investor's normal income tax bracket is 33% and calculate his net earnings.

 

VWO

EFA

Total dividend received

$1,510

$1,510

     

Qualified dividend

$75

$1,510

Tax @ 15%

$11

$226

     

Non qualified dividend

$1,435

 

Tax @ 33%

$474

 
     

Total tax

$485

$226

Net dividend received

$1,025

$1,284

     

Net earnings after taxes

68%

85%

So, although the dividend yield for VWO was 3.02% and EFA was 2.75%, the after tax return on EFA turned out to be significantly higher.

Thus, we can see that there can be a huge difference in the take home amount due to taxes. So the next time you are trying to invest in any ETF, don't forget to factor in the QDI effects and the result may surprise you.

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.