Reduce Your Tax Bite with These 10%+ Yielding Stocks

Dividend Investing, Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs)

It’s April 16th and with your tax return now tied with a bow and sent off to the IRS, you may be asking if there is a way to reduce the tax bite on your investment earnings. Fortunately, the complications of the U.S. tax code leave a few windows of opportunity that allow you to earn a high yield on certain stocks with those earnings to a large extent sheltered from income tax.

There are several possible scenarios for the taxation of stock market dividends. Dividends paid by a corporation usually meet the requirements for qualified dividends. You pay a tax rate on qualified dividends that is significantly lower than your regular, marginal tax rate, colloquially referred to as income tax.

However, many higher yield stocks use a pass-through tax structure – such as real estate investment trusts (REITs) – to not pay corporate income taxes. With these types of stocks, you pay your full tax-bracket rate on the non-qualified dividends you earn. The after tax return from a fully taxable dividend can result in a much lower net income based on the level of risk you may be taking to earn that high percentage yield. For example, with a 10% yield taxed at a federal and state 30% combined tax rate, you end up with a net 7% after-tax return from the dividends you earned.

Dividends may also be classified as non-dividend, return of capital (ROC). This can occur if the dividend paying company generates cash flow to pay the dividends that is not taxable income. Non-cash deductions at the corporate level like depreciation and depletion can result in ROC dividends. This type of dividend is not taxable income, which means you can keep 100% of ROC dividends and do not have to share with the IRS. Return of capital dividends will reduce your cost basis in the stock, so if you sell shares the dividends may be recaptured at that time as taxable income.

The chart below gives you a good idea of how you can save a pretty substantial amount on your taxes when choosing investments with qualified dividends versus non-qualified.

Dividend Taxation

Ordinary Income Tax Rate

Ordinary Dividend Tax Rate

Qualified Dividend Tax Rate

10%

10%

0%

15%

15%

0%

25%

25%

15%

28%

28%

15%

33%

33%

15%

35%

35%

15%

39.6%

39.6%

20%

So now let’s start with a short list of stock market investments that pay at or close to 10% for which you will not have to pay taxes on a large portion of the distribution income you receive from the shares.

Navios Maritime Partners L.P. (NYSE: NMM) owns dry bulk freight ships that are leased out to generate revenue. Since going public in 2008, NMM has paid a dividend every quarter, with the distribution rate growing from $0.35 per quarter to the most recent $0.4425 over the last six years. NMM currently sports a 9.6% yield. Investment earnings are reported on an IRS Form 1099-DIV and not the much more complicated Schedule K-1 used by most limited partnership type of companies. For 2013, the NMM dividends were classified as 63.8% non-dividend distribution (ROC) and the other 36.2% as tax-qualified dividends.

Each share of LinnCo LLC (Nasdaq: LNCO) is backed by one unit of Linn Energy LLC (Nasdaq: LINE), an oil and gas exploration and drilling master limited partnership. Linn Energy has paid a steady and growing distribution to investors since April of 2006. LinnCo was spun-off in 2012 to offer a 1099-DIV investment option (LINE investors receive K-1s) and provide Linn Energy with more flexibility to raise investment capital. Currently LNCO pays the same monthly distribution rate as LINE and yields 10.5%. Linn Energy forecasts the LNCO dividend will be tax-free ROC through at least 2018.

Kinder Morgan Management, LLC (NYSE:KMR) is another master limited partnership alternative with a different distribution scheme. Each KMR unit is backed by a unit of Kinder Morgan Energy Partners LP (KMP: KMP), one of the largest midstream energy companies in the U.S. Instead of the cash distributions paid by KMP, KMR investors receive additional shares of KMR (stock dividends) in the value of the distribution amount paid to KMP unit holders. The share distributions earned on KMR units are not taxable, so KMR functions as a tax-free dividend reinvestment plan based on the value of KMP. KMR currently yields 7.4%, with dividend rate forecast to grow by 5% per year for at least the next three years.

Master limited partnership companies can be great income investments, with the benefits often offset by complicated K-1 tax reporting requirements. An MLP focused closed-end fund handles all of the tax payments internally and closed-end funds investors receive IRS Form1099-DIV and earn attractive ROC dividends. The Cushing Royalty and Income Fund (NYSE: SRF) currently yields 10.8% with most, if not all of the dividends paid expected to be classified as non-dividend distributions, return of capital. Closed-end funds are allowed to use a moderate amount (typically 20% to 25%) of leverage, which allows the MLP focused funds to offset the internal tax costs and provide much higher yields than an MLP focused exchange-traded or mutual fund.

Are taxes on your dividend stocks an important factor for you when considering adding them to your portfolio? Do ROC dividends make sense for your tax situation? I’d love to hear your experience. Let me know what you think. Feel free to drop me a line at tim.plaehn@investorsalley.com.

And if you’re going to be at the Las Vegas Money Show on May 13th or 14th or just live in the area, please stop by to check out my REITs presentation and my income investing presentation. Click here for more details and to register for FREE for the presentations.

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