Tax-Efficiency and Qualified Dividend Income Percentages

10keybiggerDividend distributions from mutual funds and ETFs are either qualified or non-qualified, and the difference could have you paying double the taxes. Qualified dividends are taxed at the lower long-term capital gains rate, which varies from 0% to 20%. Non-qualified dividends are taxed at ordinary income rates, which can be as high as 39.6%. Even though they all show up as “dividends” in your account, their classification can make a big difference in your final after-tax performance.

At the end of each year, Vanguard provides a list of their mutual funds and what percentage of their dividends are qualified. Here is their 2014 report and 2013 report [pdf]. I don’t know if other fund companies do the same. The Vanguard (US) Total Stock Market Index ETF and mutual funds had 100% of their dividends as qualified for 2014 (VTSMX, VTSAX, VTI). The Vanguard Total International Stock Index ETF and funds had 72% of their dividends as qualified (VGTSX, VTIAX, VXUS). The numbers for 2013 were similar. To me, this establishes a sort of baseline expectation.

I recently made a tweak in my portfolio and replaced my value-tilted holdings with a couple of WisdomTree ETFs. While doing my 2014 taxes, I noticed on the 1099-DIV tax form that only half of the dividend distributions were counted as “qualified dividends”. What was up? I took a closer look.

Here are the specific Wisdom Tree ETFs, their closest Vanguard competitor ETFs, and their respective 2014 qualified dividend income (QDI) percentages with the WisdomTree numbers based off my 1099-DIV form:

  • WisdomTree SmallCap Dividend ETF (DES) 64%
  • Vanguard Small-Cap Value ETF (VBR) 72%
  • WisdomTree Emerging Markets SmallCap Dividend ETF (DGS) 34%
  • Vanguard FTSE Emerging Markets ETF (VWO) 37%

After comparing these numbers, I guess the WisdomTree ETFs aren’t that inefficient on a relative basis, but I’m still not very happy about it because I am holding these ETFs in taxable accounts. My current ordinary income tax rate is pretty high, and I need to figure out a way to fit these inside an IRA or 401(k) plan.

I hadn’t realized that the dividends from nearly all Emerging Markets ETFs were so tax-inefficient. (I usually just hold Emerging Markets exposure inside a Total International fund.) As the dividend yield on these Emerging Markets ETFs range from 2.5% to 3%, it makes a difference over the long-run to keep these in tax-sheltered account if possible.

By the way, I think noticing these types of things is one of the benefits of doing your income tax returns yourself. Even if you hire a professional, try running the numbers on your own and see if they match up. Even CPAs can make mistakes.

Comments

  1. If you were to hold these funds inside an IRA or 401(k) plan, though, wouldn’t all of the gains (both dividends and capital gains) be subject to ordinary income taxes (albeit deferred)?

    • Depends if you’re talking Roth or not. Yes for pre-tax plans, but you’d have the upfront tax avoidance plus the ongoing compounding growth of those dividends, which is pretty significant. Having the dividends being taxed every year makes the growth a lot less. It’s more than just deferring the taxes until later.

  2. Some international funds have a pass though foreign tax credit, which may effect your tax situation. Because of this I try to keep my taxable accounts as simple tax wise as possible. Funds that are 100% domestic with 100% historic QID and short term cash (100% ordinary).

  3. good catch! I seem to discover new things I am doing wrong with my investments every time I do taxes. But I guess that’s the advantage of doing my own taxes.

  4. Based on this how would you change your asset allocation chart?

  5. The emerging markets funds are probably lower in their percentage of qualified dividends by nature of their composition.

    Only certain “qualified foreign corporations” can produce qualified dividends.

    http://www.irs.gov/publications/p17/ch08.html

    “Qualified foreign corporation. A foreign corporation is a qualified foreign corporation if it meets any of the following conditions.
    The corporation is incorporated in a U.S. possession.

    The corporation is eligible for the benefits of a comprehensive income tax treaty with the United States that the Treasury Department determines is satisfactory for this purpose and that includes an exchange of information program. For a list of those treaties, see Table 8-1.

    The corporation does not meet (1) or (2) above, but the stock for which the dividend is paid is readily tradable on an established securities market in the United States. See Readily tradable stock , later.”

  6. I still believe that for the total international stocks, the foreign tax credits make up for the tax inefficiencies.

    IMO, the offer of tax efficiency for my portfolio would be (worst to best):
    REIT fund (currently in Roth its, small % in 401k)
    bond fund (all in 401k)
    mid cap growth (currently in 401k)
    small cap value (currently in taxable due to lack of good 401k fund for this class)
    Emerging markets (currently in taxable die to lack of good fund in my 401k)
    international TSM (mostly in taxable due to foreign tax credit, small percentage in 401k)
    S&P 500 funds (i don’t hold this fund)
    Domestic TSM (mostly in taxable, small % in 401k)

    While my portfolio placement I’d not perfect (mostly due to lack of good fund in my 401k), I believe it is efficient enough from a tax pov.

    • I agree that for total international, things aren’t too bad. But taking again my WisdomTree DGS ETF, the foreign taxes paid were just 10% of the total annual dividends. Even assuming I claimed the foreign taxes paid as a full credit, that only offsets a portion of the dividends that are taxable as ordinary income.

      • Agreed. How volatile are the WisdomTree DGS ETFs? Do you get enough opportunity to tax loss harvest those funds? If yes, that might be another thing to consider before you decide to place them in tax advantaged accounts.
        I was able to have two TLHs with Emerging market funds last year – once from VEMAX to IEMG in November, and then reverse direction in January. The TLH write offs more than made up for the non-qualified dividends from that fund.

  7. Agreed. How volatile are the WisdomTree DGS ETFs? Do you get enough opportunity to tax loss harvest those funds? If yes, that might be another thing to consider before you decide to place them in tax advantaged accounts.

    • As a comparison point, I tax loss harvested Emerging market funds twice last year. Once in November when I moved from VEMAX to IEMG; then once again in december when I moved in the opposite direction.
      Together, those TLH have more than written off any non-qualified dividends I received from them 🙂

  8. Arun Venkataraman says:

    On a slight tangent, I wonder if any of the “robo”-investing services handle this. Invest your taxable proceeds in tax favorable ETFs and your IRA/Roth proceeds in more tax unfavorable vehicles. Do you know?

    • I know that Wealthfront does offer taxable portfolios that are different than tax-deferred portfolios, for example they will include municipal bond funds for taxable investors in a higher tax bracket.

      However, I don’t know of any that specifically split things up between taxable and tax-deferred (i.e. bonds in IRA, stocks in taxable), or are “conscious” and adaptive in response to your externally-held assets.

      • Wealthfront puts everybody in muni’s in a taxable account – they don’t ask you any questions about your tax bracket.

      • FutureAdvisor does look at your entire portfolio as a whole and suggests moving the tax-inefficient funds to your tax advantaged accounts… but their algorithm leaves a lot to be desired. For example, my 401k has all the bonds that I need to hold (13% of my total portfolio), but FutureAdvisor thinks I have only 0% in bonds! It correctly suggests keeping my REIT funds in Roth IRA, and international funds in taxable.

  9. I’d like to have VEMAX in my portfolio but I’ve already maxed out Roth contributions for this year. And since the QDI is 37.13%, according to vanguard’s 2015 estimate, I’ve decided not to put it in taxable. At least I have VTIAX in taxable and a tiny amount of emerging market fund (non-vanguard with higher expense ratio) in 401K.

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