There are numerous income investments out there in the market, and many different ways in which these investments get treated for taxes. You should know how each income investment tax gets handled by the IRS. You may find that some belong inside your retirement account rather than in a regular taxable account. This could result in massive tax savings.
Income Investment Tax for Preferred Stock
Preferred Stock is probably the biggest provider of taxing trouble that investors deal with. Although income investment tax treatment of any preferred stock will always differ based on the issuer, for the most part preferred stock dividends are treated as “return of capital.”
In other words, you use capital to buy the preferred stock, but when the dividends are paid, the issuer usually considers this to be a return of a small part of the money you used to buy the stock. In other words, return of capital means it is not taxable.
Thus, you may not want to have preferred stock in your retirement account. It may be better in a regular account where you won’t get taxed on the distribution. You can find out how the tax treatment is likely to work based on the issuer’s annual declaration.
Income Investment Tax for Baby Bonds
Baby Bonds, also know as “exchange traded debt” is on the opposite end of the spectrum.
As with all taxable bonds, the distributions are made in the form of taxable interest. Baby bonds tend to be fairly high-yielding, so there may be a great deal of interest paid out. Therefore, you may want to keep these inside your retirement account unless you are in a low tax bracket, because the income investment tax treatment of these bonds could be onerous.
Income Investment Tax for REITs
REITs are all over the place.
They may pay out capital gains, return of capital and dividends taxed as ordinary income. However, those dividends may be eligible for a lower rate if you are in a lower tax bracket, if the REIT distributes dividends received from a taxable REIT subsidiary or if the REIT pays corporate taxes and retains earnings.
You should definitely look at the REITs historical record to see what it usually does as far as handling this income investment tax situation.
Otherwise, however, the REIT will distribute “non-qualified dividends”. That means that because the REIT didn’t pay taxes on that money, you will have to. These are treated as ordinary income, just like interest.
Remember that capital gains distributions can be either short or long term, with the latter eligible for the lower tax rate of 23.8%. If you have capital losses, however, then those gains will offset the losses and not result in taxation.
Income Investment Tax for Closed End Funds
Closed End Funds can be quite complicated and, again, you should look to the historical record to determine where to place these investments.
CEFs may have some distributions classified as interest — if those distributions comes from fixed-income investments. If your CEF is geared towards investing in fixed income, then you’ve got a pretty good indication that this is going to be where the majority of distributions will fall. In that case, you’re back in the same scenario as bonds since this income investment tax gets treated as interest.
If your CEF is geared towards taking positions in equity instruments, then you are likely to see both dividends and capital gains. We’ve discussed capital gain treatment already. However, the dividends from a CEF will depend on what equity investment generated those dividends. Was it a regular ol’ stock? Then it’s probably a “qualified dividend” like most stocks issue.
The tax rate on qualified dividends for those that have ordinary income taxed at 10% or 15% do not pay any tax on the dividends. Those that pay tax rates greater than 15% but less than 39.6% have a 15% rate on qualified dividends. The tax on qualified dividends is capped at 20%, which is for those individuals in the highest brackets.
But they could be non-qualified dividends, also. You have to be careful here. You’ll get a very good idea based on what the CEFs stated investment goals are.
Income Investment Tax for MLPs
MLPs are usually energy-related investments, which will be non-qualified dividends taxed as regular income. So these are best placed in a retirement fund unless you are in a low tax bracket.
Income Investment Tax for LPs
LPs, or limited partnerships, issue K-1 statements each year. These could be any or all of the above.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.