Tax Planning for Investors: Income vs. Growth

Whether you invest for income (dividends and interest), growth (price appreciation) or total return (a combination of income and growth), it’s important to assess the impact of taxes on your portfolio. Here are some of the tax issues you should consider.

Not all dividends are created equal

One benefit of dividends is that they may qualify for preferable capital gains tax rates. For the 2017 tax year, the top rate is 20% for high-income taxpayers — individuals (other than heads of household, for whom the amount is $444,550) with income over $418,400 and joint filers (and those filing as a surviving spouse) with income over $470,700. For 2017, taxpayers with income under those thresholds enjoy either a 15% rate or, for those in the lowest two tax brackets, a 0% rate.

Keep in mind, however, that only “qualified dividends” are eligible for these rates; nonqualified dividends are taxed as ordinary income at rates as high as 39.6% for 2017. Qualified dividends must meet two requirements:

  1. The dividends must be paid by a U.S. corporation or a qualified foreign corporation.
  2. The stock must be held for at least 61 days during the 121-day period that starts 60 days before the ex-dividend date and ends 60 days after that date.

A qualified foreign corporation is one that’s organized in a U.S. possession or in a country that has a current tax treaty with the United States, or whose stock is readily tradable on an established U.S. market. The ex-dividend date is the cutoff date for declared dividends. Investors who purchase stock on or after that date won’t receive a dividend payment.

Timing is everything

One disadvantage of dividend-paying stocks (or mutual funds that invest in dividend-paying stocks) is that they accelerate taxes. Regardless of how long you hold the stock, you’ll owe taxes on dividends as they’re paid, which erodes your returns over time.

When you invest in growth stocks (or mutual funds that invest in growth stocks), you generally have greater control over the timing of the tax bite. These companies tend to reinvest their profits in the company rather than pay them out as dividends, so taxes on the appreciation in value are deferred until you sell the stock.

Tax reform may change the equation

Keep in mind that tax reform may affect the benefits of income investing. Even if preferable rates for qualified dividends are retained, changes in individual income tax rates and brackets can have a significant impact. Suppose, for example, that tax rates are reduced and that the income threshold for the 20% rate for qualified dividends is lowered for 2018. If that happens, the gap between the tax rates on ordinary and dividend income would be narrowed, reducing the advantages of qualified dividends.

Seeing the big picture

There are many factors to consider — both tax and nontax — when selecting investments. Some investors seek dividends because they need the current income or they believe that companies with a history of paying healthy dividends are better managed. Others prefer to defer taxes by investing in growth stocks. And, of course, there’s something to be said for a balanced portfolio that includes both income and growth investments.

Regardless of your investment approach, it’s important to understand the tax implications of various investments so you can make informed decisions. And keep an eye on Congress so you can evaluate the potential impact of tax reform on your investment strategies.

© 2018


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