Disclaimer: This discussion centers around American tax law. If you aren’t American and don’t live in America, you may not get much value out of this.
Real talk. I thought I knew a lot about personal finance. I thought I knew everything I practically needed to know to minimize my tax bill as an average Joe passive investor. Until last week, when I realized I had a big blind spot. One that has been costing me thousands of dollars each year.
Dividends. That’s what this article is all about. Whether you invest in either individual companies, mutual funds, index funds, or ETFs, dividends make up a significant chunk of your annual returns. If you invest a million dollars in Vanguard’s Emerging Markets ETF, you might collect about $30,000 in dividends this year. Ideally this money doesn’t even see the inside of your bank account, and gets reinvested immediately. Dividend reinvestment is essential to getting high returns on your investment portfolio. But that’s not how the government sees things. As far as the government is concerned, you’ve made $30,000 in investment income, and you need to pay taxes on it. Within the next year.
So how much exactly do you have to pay? Well… that’s where things get very very tricky. The IRS considers dividends to be either qualified or nonqualified (also often called ordinary dividends). Qualified dividends get taxed as capital gains. This can be as low as 0%, but usually means 15% for most people. In contrast, nonqualified dividends get taxed at your marginal income-tax bracket. If you’re reading this article, that would most likely range from 22-35%.
To put these in concrete terms, 15% taxes on $30,000 comes out to $4,500. Whereas at a 30% tax rate, this comes out to $9,000. That’s thousands of dollars taken out of your pocket, every single year. And that number gets even larger if you have a more sizable portfolio, invested in high-dividend securities, or qualify for the 0% capital gains tax bracket.
So clearly, we would all like to receive qualified dividends. But how exactly does the IRS decide whether or not a dividend is qualified?
The Obvious Answer: How long you’ve held that security
There is an obvious answer to this question, which you might have already heard about. How long you’ve held the security prior to the dividend being paid. There is some nuance here, but here’s the requirement that applies in most cases, including company-specific stock, mutual funds, and ETFs: during the 121 day period that begins 60 days before the ex-dividend date, you need to have held the asset for more than 60 days.
Or to simplify greatly and in plain english: you did not sell the asset within two months of buying it. So if you’re a buy-and-hold passive investor, you’ve already met this requirement. The only thing to watch out for is things like rebalancing your portfolio, or doing tax-loss-harvesting, when you might end up inadvertently selling something which you had recently purchased.
Well, that was simple. Problem solved, case closed, let’s all go out for drinks. Right?
Wrong. Even though this requirement is the most widely known, it isn’t the only one. Keep reading for other gotchas.
The less obvious answer: How long the fund has held that security
Here is a related but less obvious requirement. If you’re invested in a mutual fund or ETF, another factor is how long the fund held on to the specific security that paid out the dividend.
For example, suppose you’ve invested in a Schwab mutual fund, and you haven’t bought or sold your investment for many years. However, the fund manager decides to buy a large amount of Intel stock shortly before they paid out their dividend, and then sells it immediately afterwards. Because the fund has not satisfied the 60-day holding period requirement for Intel stock, the dividends paid out by Intel to the fund would be nonqualified.
You can see this in the dividend-payout lists for an ETF like VOO – the Vanguard S&P 500 ETF. Regardless of how long you held on to your VOO investment, you can see that some of the dividends are listed as non-qualified:
An even more obscure answer: Where the company is located
Thankfully the vast majority of dividends paid out by VOO are qualified. The non-qualified dividends are a tiny amount. But consider the following ETF, also by Vanguard, also using a buy-and-hold passive investing philosophy:
Unlike the earlier ETF, the majority of dividends paid out by this one are non-qualified ($0.40 vs $0.22). It gets even worse when you consider other ETFs such as this one:
The vast majority of dividends here are non-qualified ($2.68 vs $0.19). Why is that?
The name of the ETF gives an important clue. These are the ETFs for Emerging Markets and India respectively. It turns out that there is another requirement for a dividend to be qualified. It has to be paid by “either by a U.S. corporation or by a foreign corporation incorporated in a US possession, are located in a nation covered by an income tax treaty with the US, or their stock is readily tradable in the US securities market.”
Interestingly, most dividends paid out by corporations located in developed nations do qualify. For example, see the dividends paid out by the Vanguard FTSE Developed Markets ETF:
You can see above that in the most recent payout, $0.41 was qualified, and only $0.07 was non-qualified. Even though this ETF is investing in foreign companies. In contrast, a far smaller proportion of dividends paid out in the emerging markets are qualified.
Yet another obscure answer: Real Estate Investment Trusts (REITs)
Here’s one last gotcha that you might run into. Consider the following ETF:
Unlike the earlier example, most holdings in this ETF are American corporations. And yet, every single dividend paid out by this ETF is non-qualified. Why is that?
It turns out there is yet another obscure requirement for qualified dividends. Real Estate Investment Trusts (REITs) are for the most part disqualified. For those not familiar with REITs, they allow you to invest in real-estate, without having to buy and manage any properties yourself. Even better, you get instant diversification across the entire country, as well as the liquidity of being able to buy and sell in literally minutes.
There is one downside however – REITs are required by law to pay out significant dividends, and most of those dividends will not be qualified. Something I just realized this week when I received my 1099 and found myself wondering why I had so many nonqualified dividends.
Note that there is a silver lining. You’re allowed to claim 20% of the REIT dividends as a Qualified Business Income deduction. So if you received $30,000 in dividends, all of which are taxed as income at a 30% tax rate, along with a $6,000 QBI deduction, you’ll end up having to pay $7,200 in taxes. As compared to $4,500 if you had to pay the 15% long-term-capital-gains tax on $30,000 of qualified dividends.
What You Can do About It
This is all very interesting, and depending on your investment style and portfolio, you might be feeling somewhat annoyed at this point. But what can we do about it? Is there anything we can do to minimize the tax bill associated with non-qualified dividends?
First things first – if you’re a very active trader, consider being… a little less active. Buy and hold your assets for at least 2 months to meet the holding period requirement for qualified dividends. (Strongly consider buying and holding for at least a year to qualify for the lower long-term-capital-gains tax rate as well, but that’s a different topic entirely.) If you need to rebalance or draw-down or tinker with your portfolio, try to minimize the number of shares that you’re buying and selling in rapid succession, so that the majority of your portfolio still fulfills the holding period requirement. If you’re doing things like tax-loss-harvesting, avoid selling a large number of recently-purchased shares just to realize a very tiny loss. You may wind up paying even more in taxes for nonqualified dividends.
Next, even if you’re a buy-and-hold investor, think twice about investing in mutual funds that do a lot of active trading. Because they are trading more frequently, they are more likely to violate the holding period requirement, and generate nonqualified dividends (though this depends greatly on the specific fund and its trading style). Besides, the vast majority of actively managed mutual funds perform worse than index funds, and it’s impossible to reliably predict which ones will do well, so what’s the point really.
Lastly, and this is likely the biggest insight I discovered in the past week, place any assets producing nonqualified dividends in your IRA and 401(k) retirement accounts. Dividends earned in these retirement accounts do not trigger any immediate tax bill at all! And when you eventually withdraw money from your retirement account, it is taxed in exactly the same way, regardless of the dividend classification. Hence, within the context of a retirement account, it makes no difference whether you receive a qualified or nonqualified dividend.
You can use the above insight to better balance your overall portfolio across different accounts. Suppose you have $400,000 in an IRA, and $600,000 in your personal savings account which you don’t intend to touch until retirement. And suppose your goal is to invest 20% of your portfolio in Emerging Markets, another 20% in REITs, and the remainder in the S&P 500. You could use the entirety of your IRA to invest in Emerging Markets and REITs. And your personal savings account to invest in the S&P 500. This way, the non-qualified dividends will end up mostly in your IRA, where they will not cause any problems at all. And the dividends that you get in your personal savings account will be mostly qualified, which is exactly what we want.
As some others pointed out, the math here is surprisingly complicated. REITs in a non-retirement account grant you some QBI deductions, as discussed in the earlier section. And emerging market investments in a non-retirement account grant you foreign-tax-credits, which lower your tax bill. When factoring these in, is it still preferable to place REITs and emerging market ETFs in retirement accounts? I suspect so, especially for REITs, but I haven’t done a rigorous mathematical analysis.
This approach does come with some risks. Suppose the S&P 500 tanks, and Emerging Markets experience a big boom. Thanks to diversification, your overall portfolio will still be fine, and you can always rebalance at any time to get back to your desired allocations. But tactically, you’ll find yourself with far less in personal savings, and a much larger portion of your portfolio tied up in your IRA. If you need to withdraw money immediately for a very large expense, this can become a major problem. But if you don’t need the funds immediately and are willing to wait it out until retirement, this is no problem at all.
If this all seems too complicated… feel free to simply ignore it. Giving up 0.3% in annual returns is not the end of the world. And diversifying your portfolio across real estate and emerging markets is certainly worth any tax disadvantages. But if you do want to go the extra mile, you have an opportunity to reduce your tax bill by a noticeable amount, and put thousands more dollars in your pocket each year.