With stocks at or near record levels, prudent financial planning might call for taking defensive measures. One strategy could be to focus on dividend-paying stocks. Companies that make enough money to distribute some to shareholders tend to be financially strong, and they generally have held up reasonably well during market pullbacks.

What’s more, qualified dividends offer tax breaks to investors holding them in taxable accounts; the same is true for qualified dividends passed through from mutual funds. Such dividends may receive the same favorable tax rate as long-term capital gains.

Not All Dividends Are Taxed Favorably

Most dividends paid to U.S. investors qualify for favorable taxation; exceptions include distributions from real estate investment trusts and master limited partnerships. Dividends only qualify for low tax rates, however, if they meet the holding period requirements. Investors must own common stock or a fund holding common shares for at least 61 days during the 121-day period that began 60 days before the ex-dividend date, which is the first day on which a stock buyer will not receive the next dividend payment.

For example, in early September 2019, ABC Corp. announced a dividend payable to shareholders who are on record as owning its stock on September 19, 2019 (the record date). The ex-dividend date is September 17; any seller holding ABC shares on September 17 will receive the September 19 dividend.

Suppose Marge Jones buys ABC stock on September 16—she will receive that dividend. Here, the 121-day period started on July 19 (60 days before the ex-dividend date) and goes to November 17, 121 days later. Marge must hold the stock for 61 of the days during this period for the dividend to be qualified and taxed at favorable long-term gains rates. If Marge fails this test, she will owe tax on that dividend at her ordinary income tax rate. (The comparable numbers are 91 of 181 days for preferred stock.)

Behind the Numbers: Lower Tax Rates

If dividends from investments are qualified, they receive the same tax rate as long-term capital gains. These bargain tax rates depend on the investor’s taxable income for the year the dividends are received, as shown in the Exhibit.


Bargain Tax Rates, 2019

For Unmarried Individuals, Taxable Income Over; For Married Individuals Filing Joint Returns, Taxable Income Over; For Heads of Households, Taxable Income Over 0%; $0; $0; $0 15%; $39,375; $78,750; $52,750 20%; $434,550; $488,850; $461,700 Source: http://taxfoundation.org

Because taxable income is after all deductions, a married couple, for example, might have gross income well over $80,000 and still owe 0% tax on dividends from investments. In contrast, high-income taxpayers may owe as much as 23.8% in tax on qualified dividends if they are subject to the 3.8% surtax on net investment income. In any case, these tax rates are significantly lower than the ordinary income rates that apply to interest income from bonds and income from nonqualified dividends.

When Nonqualified Tax Treatment Makes Sense

Although it may seem counterintuitive, there are situations where opting out of qualified dividend status can save tax. This might be the case when an investor has a substantial amount of investment interest expense—for example, interest paid on money borrowed to buy securities.

Even after passage of the Tax Cuts and Jobs Act of 2017 (TCJA), such interest may be tax deductible. (As before, interest on loans used to buy municipal bonds or muni funds cannot be deducted.) The interest is classed as an investment interest itemized deduction, so taxpayers who itemize deductions on Schedule A of Form 1040 might be able to take advantage.

For example, suppose Nick Morgan is in the 32% income tax bracket. He has a margin account and he pays $4,000 in interest on margin loans in 2019. Assuming that Nick will itemize deductions on his 2019 income tax return, he probably can deduct that $4,000. Why “probably”? Because this tax deduction is capped at the amount of taxable net investment income for the year. Moreover, qualified dividends and long-term capital gains (including such distributions from mutual funds) are not automatically included in taxable net investment income.

Is making the election to disqualify some or all investment dividends from the special lower rate qualified dividend status a good idea? It depends.

Suppose that Nick’s taxable net investment income for the year, excluding qualified dividends and long-term gains, is $5,000. If so, there will be no problem; Nick can deduct his $4,000 of investment interest expense and also pay reduced tax on those dividends and gains.

Conversely, suppose that Nick’s net investment income for the year, as defined above, is only $2,200. He has no long-term gains, but he does have $3,500 of income from qualified dividends. Now Nick will have to make a choice. One option is for Nick to keep his investment dividends as qualified dividends to receive the bargain 15% tax rate. In that case, Nick can only deduct $2,200 of his $4,000 in investment interest expense on his 2019 tax return; the other $1,800 can be carried forward and perhaps deducted in future years.

Alternatively, Nick can elect to include $1,800 of his qualifying dividends in his calculation of net investment income for 2019. If this election is made, Nick will have a total of $4,000 in net investment income and can deduct all $4,000 of his investment interest expense. By making this election, however, Nick will be moving $1,800 of his investment dividends from the qualified to the nonqualified side. That $1,800 will be taxed as ordinary income at Nick’s 32% tax rate, rather than as a qualified dividend at 15%. In addition, Nick will not have investment interest expense to carry forward to future years.

Is making the election to disqualify some or all investment dividends from the special lower rate qualified dividend status a good idea? It depends. Will the individual be itemizing deductions, this year and in the future? Will more investment interest expense appear in the future? More future net investment income, besides qualified dividends and long-term capital gains? Will the investor’s tax bracket move up or down in the next several years?

In addition, the alternative minimum tax (AMT) should be considered. The investment interest deduction may be greater or less than the amount deductible for regular tax purposes because of various AMT adjustments, such as interest on specified private activity bonds.

The best solution is to run the numbers both ways, see how much (if anything) will be saved in tax for the current year, and make a judgment about whether this upfront tax savings is worth relinquishing the investment interest carryforward that would occur without the election.

IRS Publication 550, Investment Income and Expenses, explains the rules on deducting interest income expense. It can be found at http://www.irs.gov/pub/irspdf/p550.pdf.

Sidney Kess, JD, LLM, CPA is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman & Co., LLP. He is a member of the NYSSCPA Hall of Fame and was awarded the Society’s Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Advisory Board.
Julie Welch, CPA, PFS, CFP is the managing shareholder at Meara Welch Browne PC, Leawood, Kans.