I was hesitant to write this chapter. In fact, I didn't even include it in the table of contents in the proposal to my publisher. I despise how complicated taxes can be. It's why this chapter wasn't in my original plans for the book. However, taxes are an important issue that needs to be addressed.

Keep in mind that I am not a tax expert. I will cover only the basics of tax law as it pertains to dividends. If you have any questions, you should always seek the advice of a tax professional.

Here's what you need to know:

Dividend tax rate = 15%

That's it. Any questions?

Okay, it's a little more complex than that.

In 2014, most Americans will pay 15% on dividends held in taxable accounts. Note, if your dividends are in a tax-deferred account, like a 401(k) or an individual retirement account (IRA), you will not pay taxes on the dividends for the year in which they were received. You may pay taxes on them when you withdraw the funds in the future.

That's been the case since 2003, when President Bush signed the Jobs and Growth Tax Reconciliation Relief Act. In 2010, President Obama extended the tax cuts that set the dividend tax rate at 15%.

If the tax cuts expire, it is expected that dividends will be taxed at the individual's ordinary income tax rate. Of course, in politics, anything can happen, and tax policy may change considerably by the time you read this.

But if you're reading this just when it was published because you ran to the bookstore or ordered it online as soon as the book was available (thanks, Uncle Bob), you will probably pay 15% tax on your qualified dividends.

There are exceptions.

If you are in the 10% or 15% tax bracket—your taxable income is less than $36,900 as an individual or $73,800 filing jointly—you will not pay taxes on your dividends. That is a huge advantage as you not only can collect income tax free but also can reinvest those dividends and not worry about having to come up with the cash on April 15 to pay taxes on those dividends.

Of course, if you stick with the 10–11–12 System long enough, your dividend income could push you into another tax bracket, which may mean that you'll have to pay the 15% or whatever the rate is when the income is high enough to change your bracket.

It would be a good problem to have but one you should keep your eye on, and if you're not already, consider working with a tax professional as your income gets close to or climbs above the limit for the 15% tax bracket.

Those in the highest 39.6% bracket, whose taxable income is $406,750 filing individually or $457,600 filing jointly, will pay 20% on their dividends, plus another 3.6% that goes toward paying for the Affordable Care Act.

Foreign Taxes

It's bad enough you have to pay U.S. taxes; now you're being asked to pay taxes in other countries? Well, yes and no. But don't worry; you're not getting taxed twice.

Depending on the tax laws of the country where the company is based, taxes may already be taken out by the time you receive the dividend.

For example, if you are paid a dividend on shares of Telefónica (NYSE: TEF), the Spanish mobile phone company, the government of Spain will help itself to 21% of your dividend payment.

When you calculate your U.S. taxes, you fill out Internal Revenue Service (IRS) Form 1116, which will generate a tax credit on the amount paid to a foreign government.

To be clear, you don't get the money back; you just won't owe taxes on the dividends to the U.S. IRS.

Paying taxes to a foreign government is a pretty regular occurrence. If you've ever owned a mutual fund that owns foreign stocks, chances are you've paid foreign taxes and had to claim the foreign tax credit before.

Some countries, like Argentina, don't tax you at all, in which case, you'll just pay the U.S. tax rate. But you're going to pay someone. Uncle Sam, Uncle Jacques, or Uncle Pedro is going to get his money. You can be sure of that.

There also can be different rules depending on the type of account you hold your stock in. For example, if you own foreign stocks inside an IRA, you are not eligible for a tax credit.

This is an important concept to understand if you are investing in a foreign stock in a tax-deferred account whose country withholds taxes on your dividends.

You'll still pay foreign taxes on that dividend and not get it back if it's in your IRA or 401(k).

For example, if you owned French oil company Total SA (NYSE: TOT) in your IRA, 30% of your dividends would be withheld by the French government. Because the stock is in your tax-deferred retirement account, you would not be eligible for the U.S. tax credit.

If you owned Total in your taxable account, you'd still pay the 30% withholding, but then the IRS would give you a tax credit for the same amount.

Canada is the exception and will reduce the withholding to zero for investments held in U.S. retirement accounts.

Additionally, your adjusted gross income may affect the amount of the foreign tax credit that you are eligible for. Be sure to talk to a tax adviser with any questions.

Tax-Deferred Strategies

In Chapter 6, I mentioned real estate investment trusts (REITs), master limited partnerships (MLPs), business development companies (BDCs), and closed-end funds, which often classify a significant portion or all of their distributions to shareholders as returns of capital.

As we discussed, a return of capital typically is not taxed in the year in which the distribution is received. Instead, it lowers the cost basis on the stock, and you will pay capital gains on the adjusted cost basis when you sell the stock.

In this example, an investor bought a stock for $10. She received a dividend of $1 per share that was all return of capital. She will most likely not pay taxes on the $1 in the year it was received. So her cost basis falls to $9 from $10. When she sells the stock, it's trading at $20. Her capital gain is $11 instead of $10 because her cost basis was lowered by the $1 return of capital.

You can also defer your taxes based on which type of account your dividend stocks are in.

For regular dividend stocks, such as Perpetual Dividend Raisers, consider holding them in a tax-deferred account, such as an IRA, 401(k), or 529 plan. That way the dividends and reinvested dividends will grow tax-free until you retire or tap the funds for college.

Look at the difference growing the money tax-deferred makes.

Let's assume you have an IRA and you're reinvesting your dividends. The portfolio starts with a 5% yield and averages 8% dividend growth and 5% annual appreciation. After 10 years, an account that started with $100,000 will be worth about $285,000 if you reinvest the $98,500 in dividends that you received.

If those same stocks were in a taxable account where you were paying 15% taxes on those reinvested dividends every year, you'd have had to shell out almost $15,000 in taxes. To do that, either you'd have to sell some shares, which would slow down the compounding machine and lower your return to a total of $262,000, or you'd have to come up with the cash.

Of course, you'll have to pay taxes on the tax-deferred account once you tap the money in it, but you also don't necessarily have to withdraw all of the money at once, allowing the majority of the funds to continue to grow tax deferred.

Additionally, if you are no longer working, theoretically your income will be lower, so your tax rate may be as well. Remember, though, that the goal of this book is to help you generate plenty of income from your investments in retirement—enough that you'll be in the upper tax brackets if you don't have the right tax strategy.

If you're collecting income from MLPs, BDCs, REITs, or closed-end funds (with significant return of capital), you're usually better off holding those stocks in your taxable account.

Since the distribution is tax deferred anyway, there is no advantage to keeping it in your tax-deferred accounts. In fact, it will be a disadvantage if it replaces another income-producing investment that will be taxed as a result of being forced to reside in a taxable account because there's no room in the tax-deferred account.

If tax law does change and dividends are taxed at your ordinary income level, you should talk to your tax advisor about ways to defer taxes on those dividends. You really want those dividends to compound tax deferred over the many years. Legally protecting them from the tax man for as long as possible is going to put thousands (quite possibly tens or hundreds of thousands) more dollars in your pocket.

This chapter is just the most basic guide to taxes and dividends. Tax law has tons of variables and nuances, so once again, I urge you to talk to a tax professional if you have any questions.

Tax Law Changes

It's impossible to predict what changes to tax laws might be coming down the road. The clowns in Washington are so focused on making the opposing party look bad (something they're quite capable of on their own) that they rarely pass any decent legislation that will benefit their constituents or the nation.

But if you hear rumors of a rate hike on dividend taxes, take a look at stocks with strong insider ownership as you may be able to collect a special dividend before the rates go up.

According to Professors Michelle Hanlon at Massachusetts Institute of Technology and Jeffrey L. Hoopes at the Ohio State University, before expected tax increases, companies, especially those with large insider ownership, often pay special dividends before the higher tax rate goes into effect.¹ These special dividends may just be the next regularly scheduled quarterly dividend but pushed up a month or two.

For example, if a company pays its dividend in early February and a tax hike is coming, management may instead pay the dividend the previous December.

We saw a lot of this kind of activity in late 2010 and 2011, when the Bush tax cuts were set to expire in January 2011 and 2012. At the time, it was believed that President Obama and the Democrats would let them expire. As a result, quite a few companies paid their dividends early to take advantage of the lower tax rates.

The Bush tax cuts did get extended, so it didn't matter. All that happened was some investors got paid in December rather than January or February.

So, the next time dividend taxes are rumored to go higher, it might pay to accelerate your investments in dividend payers to capture the dividend at a lower rate.

Summary

• The current tax rate on dividends is 15%. As of this writing, it is anyone's guess whether our brilliant and practical leaders in Washington will keep the rate the same or raise it.
• You often have to pay foreign taxes on dividends of foreign companies. But you get a credit on your U.S. taxes for any foreign taxes that were paid.
• If you hold foreign stocks in an IRA or 401(k), you will not receive a foreign tax credit from the IRS.
• Consider holding your dividend stocks in a tax-deferred account, such as an IRA or 401(k).
• Do not hold MLPs or other investments where the majority of the distribution is a return of capital in a tax-deferred account. The distribution is already tax deferred.
• If you didn't get the message yet, talk to your tax advisor with any questions.