You can delay paying taxes on dividends you receive from assets in your 401(k), but you probably can't duck those taxes entirely. For a typical 401(k) built with tax-deferred contributions, your dividend tax bill comes due when you withdraw the money from the plan, probably at a higher rate than if you had paid the taxes immediately. Only in a Roth 401(k) can you go after big dividends with tax impunity.
In taxable accounts, capital gains and qualified dividends — those paid by most U.S. companies and foreign companies traded on U.S. stock exchanges — are taxed at a 15 percent rate in the year they are paid. And there is no tax on qualified dividends if your top bracket is 10 percent or 15 percent. However, all distributions from a 401(k) are taxed as ordinary income. So you are likely to lose any tax advantage when you withdraw a dividend as part of a 401(k) distribution.
Dividends reinvested in stocks or mutual funds do not incur any immediate tax liability either. However, when you take money out of your 401(k), they will be taxed, along with everything else, as ordinary income.
Dividends from bonds and bond mutual funds never qualify for the 15 percent dividend rate. As with any 401(k) distribution, they'll be taxed as ordinary income.
Self-Directed 401(k) Plans
A few companies offer employees self-directed 401(k) plans, which allow you to invest in any investment traded on major U.S. stock exchanges, including real estate investment trusts, business development companies, royalty trusts and master limited partnerships, or MLPs. Those particular companies tend to pay higher dividend yields, but the payments typically don't qualify for the lower dividend rate. However, you can take advantage of the high yields in your 401(k) because you pay no taxes now, and if you wind up in a lower tax bracket in retirement, they might be taxed at a lower rate when you withdraw them.
Roth 401(k) Plans
If you make after-tax contributions to a Roth 401(k) plan, all withdrawals — including your dividends — come out tax-free.
Master Limited Partnerships
Although MLPs typically carry high yields, they often are prohibited even in self-directed 401(k) plans. MLP distributions — technically they are not dividends — comprise income, return of capital and "unrelated business taxable income," or UBTI. And there's the rub. If the 401(k), including a Roth 401(k), receives more than $1,000 in UBTI, the 401(k) custodian — not the account-holder — must pay tax on the amount over $1,000, at the corporate tax rate for the year in which the distribution occurs. Most 401(k) custodians don't want the hassle of dealing with UBTI. But you still can tap MLP yields by collecting juicy dividends through mutual funds that invest only in master limited partnerships.