![]() That's about a 7% difference in ending wealth. At the end of year 10, the investor will have $129,263 if none of the dividends is qualified, or $138,267 if 100% of the dividends are qualified. The power of compounding illustrates the impact of the favorable tax treatment of QDI on an investor's wealth across 10 years. The investor keeps $3,400 of the $4,000 pretax dividend payment. But if the entire dividend payment is deemed qualified dividend income, then it is taxed at the investor's long-term capital gains tax rate of 15%. At the end of year one, our hypothetical investor only keeps $2,600 of the $4,000 pretax dividend payment. ![]() If none of the 4% dividend payment is qualified, then the dividend payment is taxed at the investor’s income tax rate of 35%. We'll ignore capital appreciation and reinvest the aftertax dividend payment back into the fund at the end of each year to isolate the effect of QDI. Let's say the investor parked $100,000 in a dividend-paying fund that paid a constant dividend yield of 4% each year. Because I can't predict the future of tax policy, I'll hold these tax rates constant. This income level translates to a 2018 income tax rate of 35% and a 2018 long-term capital gains tax rate of 15%. What's the Impact? Let's assume an investor's annual income is $400,000. The bigger the differential between investors' income tax rate and long-term capital gains tax rate, the more they stand to gain by increasing the portion of qualified dividend income. It's worth pointing out that the income breakpoints between both tables do not line up cleanly as they had prior to the 2018 tax reform. ![]() 31, 2017, and April 30, 2018, for the dividend payment to be eligible for the preferential tax treatment.ģ) Special structures such as real estate investment trusts and master limited partnerships do not qualify for favorable dividend income treatment.Įxhibits 1a and 1b display the new 2018 income tax and long-term capital gains tax brackets. For example, if a stock's ex-dividend date is March 1, 2018, the investor must hold the shares for more than 60 days between Dec. corporation or qualified foreign corporation makes the dividend payment.Ģ) The fund (or individual investor) holds the security for at least 61 days out of the 121-day period that began 60 days before the security's ex-dividend date. QD 'Aye' Ordinary dividend income is considered "qualified" if it meets certain criteria:ġ) A U.S. Thus, the higher the percentage of a fund's dividends classified as QDI, the more money taxable investors take home after taxes. Qualified dividends are currently taxed at a rate of 0% to 20%, depending on an investor's tax bracket, rather than at the same rate as ordinary income tax rates. The Jobs and Growth Tax Relief Reconciliation Act of 2003 made dividend payments more attractive because it introduced a lower tax rate for qualified dividend payments. Many investors turn to dividend-paying stock funds for investment income. ![]() In this article, I'll zero in on an often overlooked source of tax costs and examine the topic of qualified dividend income, or QDI. Fortunately, investors have a good amount of control over these two important factors. The less you fork over to Uncle Sam, the more you pocket. Vanguard founder Jack Bogle has succinctly summarized the effect of fund fees: "In investing, you get what you don't pay for." The less you pay to an investment manager, the more you keep for yourself. A version of this article was published in the March 2018 issue of Morningstar ETFInvestor. ![]()
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