With apologies to the Founding Fathers, we hold this truth to be self-evident: Not all dividends are created equal. Just like long-term and short-term capital gains, dividends are subject to different tax rates depending on whether they’re considered qualified or nonqualified. Nonqualified dividends are taxed at higher ordinary income tax rates, whereas qualified dividends are taxed at the much more favorable capital gains rate.
So investors should do all they can to avoid paying tax on nonqualified dividends, right? As we’ll see, not necessarily. But before we get to that, let’s review what makes a dividend qualified or nonqualified.
Qualified vs. nonqualified dividends
First of all, to be considered qualified, dividends must come from an approved source, such as a public company’s stock. Real estate investment trusts (REITs) and master limited partnerships (MLPs) also pay out dividends, but in those cases a portion of the dividends is passed through as ordinary income and isn’t considered qualified. On the other hand, most dividends paid on American Depository Receipts (ADRs), which some investors use to access foreign securities as part of their international strategy, are considered qualified.
Second, qualified dividends must meet certain holding-period requirements. The investor must own the stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (that is, the cutoff date after which an investor who purchases shares in the stock isn’t entitled to collect a dividend payment for that dividend period). If the stock is held for less than 61 days, the investor must pay ordinary income tax rates on the dividends.
For example, let’s say an investor purchases 1,000 shares of XYZ on June 1. The ex-dividend date for XYZ is June 15. On July 15 the investor sells 400 shares of XYZ. The remaining shares are held for the rest of the year. Since the investor held only 600 shares for the required holding period, the dividends on the 400 shares sold in July would be considered nonqualified and taxed as ordinary income. The remaining 600 shares meet the holding requirements and are considered qualified—and hence taxed at the lower long-term capital gain rate.
But what about the nonqualified dividends paid on the 400 shares that were sold that will be taxed at ordinary income rates? Isn’t that a potentially large and bitter tax pill to swallow? Not necessarily, and for reasons that also have to do with tax—namely, loss harvesting.
The tax value of short-term realized losses
Tax-managed separately managed accounts (SMAs), such as Parametric’s Custom CoreTM, have a dual mandate of tracking a benchmark on a pretax basis while also enhancing after-tax returns. They do this through harvesting losses, managing around positions with unrealized gains, and in some cases deferring the realization of capital gains.
In our experience, given the structure and typical trading pattern of Custom Core accounts, almost all dividends meet the minimum holding period to be qualified. In fact, we looked at a sampling of approximately 1,000 Custom Core accounts over various time periods and found that over 99% of the dividends in those accounts met the minimum holding period for qualified dividends.
Yet the number of cases in which accounts had nonqualified dividends—usually because the accounts were either newly started and funded in cash or had a large contribution followed by a large drop in the market, triggering an opportunity for loss harvesting—aren’t insignificant. And what we’ve found is that in these cases the tax value of the short-term realized losses far outweighs the taxes owed on the nonqualified dividends.
How so? Let’s look at another example. Assume an investor purchases $1,000 worth of stock and sells the stock at a $100 loss prior to the required 61-day holding period to be eligible for qualified dividend status. The tax benefit of selling the position is $40.80. Since the dividend is nonqualified, it’s taxed as ordinary income. As a result, the investor would pay just $0.85 more in taxes on the dividend, assuming maximum tax rates. As the below table makes it plain to see, the tax benefit of selling the position at a loss far outweighs the additional taxes paid on the dividends.
The bottom line
Dividends are taxed at different rates, and it’s important for investors to understand the tax ramifications of their dividend-paying securities. While nonqualified dividends may be a relative rarity in most tax-managed SMAs, in cases where securities aren’t held long enough to qualify for the lower capital gains tax rate, the benefit of the losses realized by selling the position outweighs the cost of paying a higher tax rate on the nonqualified dividend.
Potential Parametric solution
One of the primary drivers of tax efficiency in a tax-managed Custom Core® account comes from tax-loss harvesting. Parametric portfolio managers will sell a basket of securities at a loss and simultaneously replace it with a different basket of purchased securities. The trade results in net tax losses for the client, which can offset capital gains realized by other parts of the portfolio.
Rey Santodomingo, CFA, Managing Director of Investment Strategy
Rey is responsible for all aspects of Parametric’s tax-managed equity strategies. As one of the primary strategists for Custom Core®, he works closely with taxable clients and advisors to design, develop, and implement custom portfolio solutions. Prior to joining Parametric in 2008, Rey was a vice president in product management at MSCI Barra. He earned an MA in financial engineering from the University of California, Berkeley, and a BS in chemical engineering from the University of California, Santa Barbara. A CFA charterholder, Rey is a member of the CFA Society of Seattle and a prior board member of the CFA Society of Seattle. He has also served as an adjunct instructor at Seattle University's Albers School of Business and Economics.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.