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Advise Clients Seeking Dividends About the Tax Consequences of Their Investments

October 9, 2021 Steve Zuschin By Steve Zuschin

You won’t often find the Robinhood crowd swooning over investments in stable, high-performing companies that pay dividends. But you will have clients attracted to the steadiness of businesses that regularly share their earnings with shareholders by paying dividends.

For those clients, you’ll want to explore and explain the tax consequences of dividends – and how selecting the accounts where they hold dividend stocks will be vital in making those investments both income-producing and tax-efficient.

LifeYield technology solutions help advisory firms locate client investments in accounts with the best potential for tax efficiency. That is, they help clients, including those with investments that produce dividends, pay the taxes that they are legally obligated to pay.

When advisors take a unified management household approach to client wealth, that can mean significantly more accumulation over time, including investing that produces dividends. Clients benefit from increasing the value of the assets they will someday convert to income.

For clients entering the “income phase” of their financial lives, dividends can mean continued value accumulating with relatively low risk to their total portfolio value.

Let’s look at some of the tax consequences of dividends, which types of accounts to locate dividend stocks, and what you can do to provide value to your clients with portfolios that pay dividends.

Dividends Defined and Explained

Dividends are payments to shareholders who have stock in a company. Boards of directors vote on dividends, which are generally paid quarterly. Not all companies pay dividends to shareholders. Instead, they may use profits to reinvest in their businesses – with the eye on future growth and increasing shareholder value – or, sometimes, to buy back stock.

There are several different types of dividends and dividend arrangements that companies may use to pay shareholders:

Tax-Qualified and Nonqualified Dividends

Investors gain a tax advantage through a lower tax rate on tax-qualified dividends. Three factors contribute to determining if a dividend is qualified for preferred tax treatment:

  1. The dividend is paid by a U.S. corporation or qualifying foreign entity. Investors in individual stocks, mutual funds, or exchange-traded funds (ETFs) fulfill this requirement.
  2. It is a dividend in the eyes of the Internal Revenue Service (IRS). Some things called “dividends” do not qualify as dividends, including premiums and insurance company returns, annual distributions from credit unions, and dividends from co-ops or tax-exempt organizations.
  3. An investor didn’t hold an underlying security long enough. Investors must own a security for more than 60 days during a 121-day period that began 60 days before the ex-dividend date. (The ex-dividend date is the cutoff date for a shareholder to have bought stock to be eligible for a future dividend payment).

Mutual Funds and Dividends

As an advisor, you may have clients who own shares in mutual funds but perhaps don’t know – or have made a poor choice – how to direct where to pay those dividends. There are three ways that mutual funds typically earn a return:

These apply to the many common types of mutual funds: equity, fixed-income, index, balanced income, international/global, specialty and ETFs.

Your clients may have mutual fund investments that earn dividends in taxable or tax-advantaged accounts. How and if dividends are taxed depends partly on which type of account the mutual funds are held.

Different Types of Investment Accounts

Investment accounts generally fall into two categories – taxable and tax-advantaged. A brokerage account is the primary example of a taxable account. Investors with brokerage accounts owe taxes on dividends and capital gains. The tax rates on those earnings depend on how long investors hold them.

Tax-advantaged accounts may be either tax-deferred – meaning earnings taxed at a later date – or tax-exempt. Municipal bonds and tax-exempt mutual funds are examples of tax-exempt investments.

Tax-deferred accounts include traditional individual retirement accounts (IRAs) and 401(k)s. Investors don’t pay income tax on their contributions (up to limits set by law or by the sponsors of the retirement plans); their tax bills are due when they withdraw money for retirement.

Because of these varieties of accounts and their tax status, choosing where to place investments can have short- and long-term consequences for an investor.

For example, dividends on investments held in a tax-deferred account, like a 401(k), can be reinvested without near-term tax consequences. This allows the account to grow in value in anticipation of when a client will begin withdrawing money for income in retirement.

As a rule of thumb, investors strive to hold assets with lower tax rates in taxable accounts and investments subject to higher tax rates – ordinary income and short-term capital gains – in tax-advantaged accounts.

Here are examples of strategies for investors who are acquiring wealth with an eye on getting the most tax efficiency out of their investments:

Taxable accounts Tax-advantaged accounts
Individual stocks held for at least a year Individual stocks held for less than a year
Tax-managed stock funds, index funds, ETFs Managed stock funds that generate short-term gains
Qualified dividend-paying stocks/mutual funds Taxable bond funds, inflation-protected bonds, high-yield bond funds
Series I bonds, municipal bonds Real estate investment trusts (REITs)

Unified Managed Household Approach Promotes Tax Efficiency

If you can demonstrate how to improve the tax efficiency of client portfolios, you will get their attention – and their referrals. If you can do this by including a client’s spouse or partner, you’re taking the unified managed household approach to asset management.

Clients who are part of households ought to be interested in managing their separate investments as a unit to get the maximum tax efficiency. In reality, many wait too long into years of investing for retirement before stepping back to scrutinize the household portfolio.

By using a unified managed household approach, your firm evaluates a client household’s entire portfolio (including those investments with dividends), intending to find the most tax-advantaged location for those investments.

LifeYield Asset Location technology, available as APIs to integrate with your firm’s client management and account management tools, evaluates the tax efficiency of a household portfolio. It assigns a dollar value to the potential tax savings over different time horizons for a client household by locating assets in the most efficient investments for tax purposes.

Investor accounts are not only the sum of their parts. They are complex and dynamic – and subject to changing laws and market forces. LifeYield lets your firm help investors locate assets for maximum tax efficiency, rebalance accounts to hew to investors’ risk tolerance, minimize the costs of their investments, and optimize their Social Security filing strategy.

After all, returns aren’t the end game for many of your clients: Income in retirement is. And when you can save on taxes, you are reserving more for income that will pay for the lifestyles your clients desire.

Steve is the EVP of Advisor Success at LifeYield. He's responsible for leading our Direct-to-Advisor channel and always keeps up on the latest advisor technology. Steve writes about how advisors can grow their business by building stronger relationships with clients and adopting new technology.