How to Beat Uncle Sam — and Get a 7.2% Dividend

Like many veteran investors, dividend-paying stocks have always been a staple of my investing strategy.

Dividends have represented more than 50% of the total market return since 1926, according to BNY Mellon Asset Management. Investors putting their money exclusively in growth stocks that pay no dividends have a high hurdle to overcome if they want to achieve the same return.

#-ad_banner-#The problem is that dividends are taxed at 15% annually. This means you risk losing $15 on every $100 of dividends. That paltry 2% yield you get from your S&P 500 stocks is really about 1.85% after taxes. Add this to the annualized 3.4% aftertaxes  from the S&P 500 during the past 10 years, and you might need to reassess your retirement plans.

How does working until you’re 80 sound?

But there is a group of stocks that offer high income and tax advantages. One stock in particular even pays almost four times the yield of the average S&P 500 company while shareholders can enjoy the dividends without paying hardly any taxes.

Normally, when a stock offers an extremely high dividend, you need to look closely at the sustainability of the company’s payout. Is it paying out too much to grow the business or has the stock price plummeted so much that the dividend yield increased? But this company produces 20% more cash than needed for dividends and has had enough left over to acquire $3.4 billion in assets during the last year.

I’m talking about oil and gas company Linn Energy (Nasdaq: LINE), which is structured as a master limited partnership (MLP).

The pay later, or never, investment
As an MLP, the company does not pay taxes on income, as long as a certain percentage is paid to investors. Shareholders file an IRS Schedule K-1 form that details their percentage ownership of the total income and expenses. Taxes are then paid on the excess income, but because most MLPs are capital-intensive energy companies, there is a lot of depreciation that can offset income. This means there’s almost no yearly tax liability. Though similar to dividends, MLPs offer distributions, which are taken as a return of capital instead of income. In addition, no taxes are due until investors sell the shares.

Admittedly, the tax filing gets more complicated when selling shares, because investors have to account for all the money they received and which paid no taxes. Some of this is taxed as ordinary income rates and some as capital gains. The kicker is that the tax basis for an MLP investment is reset to the current market value when passed through an estate, so the tax liability from all those distributions is eliminated. Investors who keep these investments for life pay no taxes on the dividends.

Not all MLPs are created equal
As the best of breed within its sector, Linn Energy  is up almost 11% in July . The company has paid distributions since the beginning of the year and has returned an annualized 19% since trading began in 2006. The oil and gas company developed a competitive advantage buying mature energy fields and then squeezing every last drop out of them. Linn has taken advantage of cheap natural gas prices and made $3.4 billion worth of acquisitions in the past year.

Upon acquisition, the company hedges the price risk on production through derivative investments. With contracts to sell production at prices well above current market rates through 2017, revenue is tied to volumes instead of more volatile energy prices. This means that a healthy acquisition program could increase revenue and the quarterly distribution. Revenue more than doubled in 2011 to $1.6 billion compared with the previous year, and earnings are expected to rise by almost 16% in the next four quarters to $1.93 a share.

The quarterly dividend has increased from $0.32 in 2006 to $0.73 in 2012, and maintained throughout 2009 when energy prices plunged. Second-quarter earnings results are scheduled on July 30 and the next ex-dividend date should be around the first week of August.

Risks to Consider: Even with a fully hedged production profile, falling energy prices affect sentiment for the shares and can lead to a decline in price. Investors should look past any short term declines and focus on the stable dividend yield and long term strength in the business.

Action to Take — >  Linn Energy, like other MLPs, are more appropriate as long-term investments. You get cash in hand each quarter and give the government an IOU on the taxes. The deferred taxes can be eliminated through an estate or greatly reduced if shares are sold during retirement.

P.S. My colleague Amy Calistri makes a living researching the best dividend-paying stocks on the market. Right now, she’s earning over $1,350 a month in dividend payments using her “Daily Paycheck” strategy, and she’s helping thousands of people do the same thing. Click here to find out how you can start collecting your own “Daily Paychecks” right now.