This Overlooked Nuance Could Haunt You on April 15th
Have you ever experienced something that made you really excited and entirely let down at the same time? That’s what happened when I saw this:
It was the “Headline” to a Bloomberg TV segment.
A caption on the screen for the segment read “Dividends Over Day Jobs.” I’ve been telling my fellow millennials the same thing for years. I was excited that Gen Z got the memo about the power of dividends, but disappointed they were taking action before my own generation.
The letdown grew as I watched the segment, and I’m sure you know why: 90% yields!
We don’t even need to run the math to know that’s not sustainable long term.
A stock with a super high yield means one (or both) of two things are true: a really low share price, or a really high dividend. Both are reasons to question the investment and take a closer look.
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Gen Z, however, isn’t looking at owning shares of company stock. This trend is about investing in derivative income ETFs.
Their popularity has exploded over the last few years:
Source: Natixis
Derivatives are any financial contracts whose value is derived from an underlying asset. Options are the most commonly used contracts. Forwards, futures, and swaps are other types of derivatives that could be used. I’ve said before that I generally don’t invest in these types of ETFs. I prefer to trade my own options, but that’s not why I’m bringing them up today.
Always Read the Fine Print
Some ETFs pay out income to shareholders, but it’s not actually a dividend. By definition, a dividend is paid out of a company’s profits. You’ll only receive a dividend if the fund’s holdings are companies.
Fixed income ETFs hold a basket of bonds, so the “dividend” you collect is actually interest. And there are other possibilities. The money you receive from a fund could also be considered a short-term capital gain. In this case, no matter how long you’ve held your shares, this “dividend” will be taxed at your ordinary income rate.
The type of income to keep watch for when you invest in any high-yield or derivative ETF is return of capital (ROC).
ROC means the ETF is returning some of your investment. It would be similar to getting some of your principal back from a CD or other fixed investment. Since it’s a return of your money it won’t be taxed. That fact is not itself a red flag, but it could be.
First, you want to know why you’re receiving ROC. Derivative ETFs hold assets like options that have a time component, which can result in uneven streams of income into the fund. If a fund lacks the income needed to pay a distribution, part or all of the payment can be marked as ROC. Asset values are replaced by the success of the investments in the future. If the NAV of the fund continues to drop with each payment, that could be a red flag.
Second, you must decide if ROC fits your tax strategy.
ROC will lower the cost basis of your original investment in the eyes of Uncle Sam. This happens every time you receive ROC. When you sell, your taxable amount of capital gains will be calculated using this lower cost basis. If you hold shares until your cost basis drops to $0, all additional ROC distributions will be taxed as capital gains.
Create Your Specific Guidelines
I am not a tax professional and none of this should be considered tax advice. Only you can determine if you’re okay with ROC and getting taxed at your ordinary tax rate.
For some perspective, most dividends from American companies are considered qualified if you hold the stock for more than 60 days. Qualified dividends are eligible for special tax treatment at a lower rate. Dividends can also be considered ordinary, which includes distributions from REITs and MLPs. Ordinary (nonqualified) dividends are taxed at your regular income tax rate.
The type of account you’re shares will be held in—tax-advantaged or taxable—is another consideration.
I personally don’t mind if a distribution is taxed at my ordinary tax rate. If you embrace the mantra “dividends over day jobs,” it’s the same as picking up an extra shift without punching the time clock. Why not use it if it gives you more free time?
So, before adding an ETF to your portfolio, make sure you understand how your dividends will be taxed. The most accurate source will always be the distribution announcement from the issuing fund.
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For more income, now and in the future,
Kelly Green
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