Source: 401(k) 2013.

Personal-development guru Stephen Covey may have hit investing gold with this one quote: "Begin with the end in mind."


The most important thing any investor can do is think for the long haul. Think about returns after taxes -- how much of your investing results will flow to your bank account.

Business development companies aren't taxed at the corporate level. All taxes are paid at your personal tax rates. So let's take a deep dive into how BDC returns are taxed, to reveal your expected after-tax return on your investment.

Four types of BDC dividends
Business development companies are basically just publicly traded funds of private company debt and stock. Being funds, they pay distributions that are taxed in four different ways -- either as income, capital gains, dividends, or returns of capital.

 Here's a quick run through the four types of distribution.

  • Income. This is money earned from fees and interest, generally earned on loans and preferred stock in a BDC's portfolio. You'll pay normal income taxes on these distributions.
  • Non-qualified dividends. Non-qualified dividends are dividend income paid that doesn't qualify for the preferential dividend tax rate. This is taxed at the ordinary income rate -- your personal marginal tax bracket.
  • Qualified dividends. These are funds paid to the BDC from investments in common stock in private companies that qualify for taxation as dividends. Long-term capital gains and dividends were formerly taxed at the same rate and thus combined in some BDCs.
  • Return of capital. This is your money coming back to you. This is not income of any sort, just funds that were returned from the BDC's investment capital. Returns of capital are not taxed, just as you aren't taxed for taking money out of a bank account.

Different BDCs pay out different types of dividends. Most pay out all three kinds of taxable dividends. I went back to three leading BDCs and found the past three years of dividends paid to see how the tax treatment varies.

Here's a table of how BDC dividends were taxed by year. Note that I have combined long-term capital gains and dividends where appropriate because they were both taxed at 15% before 2012.

BDC

Ordinary vs. Qualified Dividends, 2010

Ordinary vs. Qualified Dividends, 2011

Ordinary vs. Qualified Dividends, 2012

Main Street Capital

81.33% ordinary, 18.67% qualified

73.94% ordinary, 26.06% qualified

53.53% ordinary, 46.47% qualified

Prospect Capital

62.06% ordinary, 9.32% qualified

(28.62% return of capital)

73.85% ordinary, 13.08% qualified

(13.07% return of capital)

43.39% ordinary, 56.61% qualified

Ares Capital

98.83% ordinary, 1.17% qualified

77.66% ordinary, 22.34% qualified

91.73% ordinary, 8.27% qualified

Source: Company press releases and websites.

BDC payouts and their tax treatment can vary tremendously from year to year. Main Street Capital, which has more equity investments in its portfolio, pays out the most qualified dividends because more of its earnings are from dividends and capital gains. That bodes well for Main Street Capital shareholders, since many pay a much lower tax rate on dividends than they do ordinary income.

Ares Capital and Prospect Capital pay out significantly more ordinary income to shareholders, so their total after-tax yield is lower than it might otherwise appear. If you owned Ares Capital and earned in the top tax bracket in 2012, you'd pay 35% income taxes on 91.73% of your dividends. Obviously, paying such a high tax rate on the overwhelming majority of Ares Capital's distributions would cost you nearly a third of your total after-tax yield.

In Prospect Capital's case, it returned capital to shareholders following the recession, which gave its shareholders a consistently high dividend, but as much of 28% of it was just investors' money coming back. Prospect Capital has since built up a surplus of undistributed income, and returns of capital this year or next look unlikely.

Forgetting the headache
If you're like most investors and would prefer to forget the tax consequences of BDC dividends, there's an easy solution: Hold them in a 401(k) or IRA. Unlike MLPs, you can hold a BDC safely in a retirement account so that the dividends are taxed like any other gain or dividend. In many cases, especially when you earn in a marginally high tax bracket, putting a BDC in a retirement account will reduce the tax impact and result in higher after-tax returns. 

The best dividend stocks on the market
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notability of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.

 

The article How Are BDC Dividends Taxed? originally appeared on Fool.com.

Fool contributor Jordan Wathen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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