One of the most powerful ways to invest in the stock market is to buy high-yield dividend stocks and hold them for the long term. These investments provide
regular cash distributions that can really add up over time.
Take Coca-Cola, a favorite among dividend-stock investors. If you invested $10,000 in Coke 20 years ago, you'd be sitting on roughly $10,000 in dividends alone -- not to mention the nice share appreciation as Coke's stock price has quadrupled.
Some investors simply like the additional profits of dividends, while others see their quarterly payments as "paychecks" that are a reliable income stream in retirement.
But whatever your mind-set is, it's crucial to get the tax forms right. There are a host of investments that deliver regular payments to investors, but not all of them play by the same rules.
Here are five tips to make sure you file your dividend taxes correctly:
--Trading around a dividend date can hurt you. "Qualified dividends" are taxed at long-term capital gains rates, but "unqualified dividends" are taxed as ordinary income, at a higher rate. To ensure your dividends are qualified, you must have "held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date," according to the IRS. If that language is confusing, check out the case studies at IRS.gov. But the bottom line is that buying or selling a stock close to a dividend date could mean a higher tax rate.
--Some investments are "unqualified" payers. Some very common investments do not pay qualified dividends, and are subject to higher taxes regardless of the holding period. The tax code says qualified dividends come from "domestic corporations and qualified foreign corporations." In other words, if your underlying investment isn't set up as a corporation or is domiciled overseas, there's a chance your dividends are subject to higher tax rates. A list of holdings that aren't qualified include bond funds, emerging market investments and real estate investment trusts.
--Dividends on deposits don't count. Another area that misses out: dividends paid on your deposits with mutual savings banks, cooperatives, credit unions, and savings and loan associations. All these are categorized as interest income and are subject to your marginal tax rate. Check out a full list of other unqualified dividends at IRS.gov.
--The MLP mess. Over the last few years, many investors have piled into master limited partnerships in pursuit of big dividends. But MLPs are structured very differently from your average corporation, since an MLP pays no tax itself and is simply a pass-through entity. As a result, "distributions" from these investments are not even considered dividends in any form by the IRS; they are treated as a return of capital to a partner -- even if you only own one share. So expect a different tax form (a K-1 instead of a 1099) and a wholly different set of rules than from your typical dividend investment. The National Association of Publicly Traded Partnerships tries to unravel this in a handy tax guide that all MLP investors should review if you need more clarification.
--High wage earners beware. The deal that averted the so-called fiscal cliff a few months ago brings the first major tax increase on high earners in 20 years.
If you have more than $400,000 in taxable income or are filing as a couple with $450,000, your top marginal tax rate has risen and so have your taxes on long-term capital gains and dividends. If you're a high earner, keep this in mind when you file your 2012 returns.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor's Guide to Finding Great Stocks.
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