5/25/08

Capital Gains, Dividends, and Taxes

I've come across these questions several times in the last few days, so I thought I'd answer them to dispel some intuitions novice investors have.

1. If I reinvest my dividends, do I have to pay taxes on them?

Whether you reinvest your dividends or not, this decision will never (unless tax laws are changed) affect your taxes. Whether your dividends are taxed depends on what dividends you're talking about and in what kind of account you're receiving them.

Let's start with regular stocks--like the ones traded on NYSE, NASDAQ, and Pink Sheets. In a regular, taxable brokerage account, or if you buy directly from the company in a taxable account (e.g., not as part of a 401(k), etc) you have to pay taxes on all your dividends. It does not matter if you reinvest your dividends or not. There are two ways in which regular stock dividends are taxed: ordinary income and qualified dividends.

The ordinary income tax rate on dividends, or the ordinary dividend tax rate, is based on whatever tax bracket you're in. Let's say you're in the 25% tax bracket. That is how much tax you'd pay on your dividends if they're taxed as ordinary income.

The qualified dividend rate, at least for now, is much lower. It also depends on your tax bracket, but the maximum rate is 15%. For people in the lowest tax bracket, the rate on qualified dividends is 0%. This will probably change in the future, especially if the Democrats control all the branches of the government.

The way your regular stock dividends in a taxable account are taxed depends on how long you hold the dividend paying stock. If you hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the ex date, etc is explained here), your dividends are taxed at the qualified dividend rate.

Many companies also have preferred stocks, which trade on the exchanges like regular stocks. These usually pay out a big dividend, have a narrow trading range, and the company reserves the right to buy the stock back for a certain price. If the company goes out of business, holders of the preferred stock have priority over holders of the regular stock in terms of who gets what of the company's remaining assets (the order of priority is bondholders, preferred stockholders, and regular stockholders).

There are two types of preferred stocks. The most common is a hybrid between a bond and a stock. The "dividends" the company pays out on these preferred shares are treated as debt. The company gets a tax break. As an investor, however, you incur the ordinary dividend rate, no matter how long you hold the stock. Only around 100 companies (mostly utilities) have preferred shares that pay out dividends that can, if you hold them for the requisite period, be qualified dividends. They typically have lower yields.

There are also tax exempt "dividends." These come from municipal bond mutual funds and closed end funds that invest in municipal bonds. Here is a great article on such closed end funds. I put dividends in scare quotes because they're not really dividends. The payments you receive from municipal bond funds are actually tax free interest payments. Depending on the fund, some, usually a very tiny percentage, of the payments you receive may count as something called "private activity bond interest." This "is interest paid by private activity bonds, issued to encourage private-sector investment in the development of certain facilities which serve various specified public purposes, and exempt interest dividends paid by mutual funds that are attributable to such interest." Private activity bond interest has tax implications. While municipal bond interest is exempt from federal taxes, you may still have to pay state taxes on your "dividends."

2. If I reinvest my profits or capital gains, can my taxes be deferred or exempt?

No. Every time you sell an asset for a profit in a taxable account, you incur tax liability. It does not matter if you use your profits to invest in something else.

There are two types of capital gains: short term and long term. Short term capital gains are taxed as ordinary income. Whatever tax bracket you're in is the rate at which your profit is taxed. For simplicity's sake, let's take a regular stock as an example. Suppose you buy GE in a taxable account, hold it for less than a year, and then sell it for a gain of $200. Let's say you're in the 25% tax bracket. You'll have to pay $50 in taxes (25% of 200).

Long term capital gains rates also depend on your tax bracket, but they are lower than the ordinary income rate. The maximum tax rate on long term gains is 15%. Taking the same example, suppose you buy GE in a taxable account, hold it for over a year, and then sell it for a $200 gain. Suppose again that you're in the 25% tax bracket. You'd have to pay $30 in taxes.

Here is a great little calculator for short term and long term capital gains taxes. The thing to remember is that to qualify for long term capital gains rates you have to hold your stock for at least a year and a day.

Mutual funds and ETFs (some, not all) pay out dividends, some of which can be counted as ordinary dividends, qualified dividends, short term capital gains, and long term capital gains. It depends on what the fund invests in and what the fund manager does. The more active the manager is in trading stocks, the more likely you are to receive ordinary dividends and short term capital gains. Once again, it does not matter whether you reinvest your mutual fund and ETF dividends. As long as you hold them in a taxable account you're going to pay taxes on them.

The way to avoid taxes on your capital gains and dividends is to receive them in a tax deferred (such as an IRA or 401(k)) or tax exempt account (such as a Roth IRA). With an IRA, you only pay taxes when you start taking money out after retirement. With a Roth, you pay no taxes, since you're investing with after tax money. For more on this, click here or here.

The bottom line is that reinvestment has nothing at all to do with taxes. Whether you pay taxes (and what rates) depends on what kind of account you're holding your assets in, how long you hold them, and what kinds of assets they are.