Speaking Mathanese: Dividend Taxes

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Welcome back to another edition of "Speaking Mathanese," our Motley Fool series that tackles financial math myths and deconstructs the computations that make the biggest difference to your bottom line.

This week, our quest to make you smarter than a fifth-grader has us casting off the capital gains tax to divine the details of the dividend tax.

The myth
Remember our quiz? To review, I asked you to tell me what the capital gain would be had you bought 100 shares of each of these stocks and held them for exactly one year:

Company	Closing Price 6/26/06	Closing Price 6/26/07	Per-Share Dividends Pd.
Amazon (Nasdaq: AMZN)	$36.77	$67.48	$0.00
Boeing (NYSE: BA)	$83.89	$94.98	$1.30
Microsoft (Nasdaq: MSFT)	$22.82	$29.52	$0.39
Procter & Gamble (NYSE: PG)	$55.99	$61.19	$1.28
Volcom (Nasdaq: VLCM)	$28.51	$46.43	$0.00

Source: Yahoo! Finance

Last time, we didn't account for dividends in figuring capital gains tax. But dividends aren't tax-free, and three of these stocks paid dividends -- Boeing, Microsoft, and Procter & Gamble:

Company	Dividends Paid
Boeing	$130.00
Microsoft	$39.00
Procter & Gamble	$128.00

So, we'd pay taxes on these amounts as ordinary income, right? Right?!?

The math
Not exactly. Some dividends are "qualified" and, thereby, taxed at more favorable rates. What's a "qualified" dividend? Here's how our friends at Investopedia define it:

A type of dividend to which capital gains tax rates are applied ... In order to qualify: (1) The dividend must have been paid by an American company or a qualifying foreign company, (2) The dividends are not listed with the IRS as dividends that do not qualify, (3) The required dividend holding period has been met. [Emphasis mine.]

Confused? I was too, till I read up on the rules in Publication 17, provided by the IRS here, if you're that type. If you're not (good for you), allow me to summarize.

First, the U.S. government has tax treaties with dozens of countries. Stocks operating under a tax treaty usually pay qualified dividends. GlaxoSmithKline (NYSE: GSK) of the U.K. and Tata Motors (NYSE: TTM) of India are two examples.

Second, some types of dividends are unqualified. An example could be interest paid to you by a credit union. Most CUs will call that a dividend. The IRS won't, and you'll have to pay taxes on the distribution at your ordinary income tax rate.

Third and finally, the Feds require that you hold stock that pays you a dividend for at least 60 days after the ex-dividend date -- that is, the date at which you must have been a shareholder of record to receive a payment. Sell earlier than that, and you'll be forced to record the proceeds as ordinary income. Otherwise, you'll pay no more than 15%.

Or, in Mathanese:

Tax = Dividend x no more than .15 (for qualified dividends)            

Tax = Dividend x your normal tax rate (for unqualified dividends)

Still have questions? Submit them here, and I'll see you next week for more Mathanese.

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Amazon is a Stock Advisor selection. Microsoft is an Inside Value recommendation. Volcom is a two-time Hidden Gems pick. GlaxoSmithKline is an Income Investor recommendation.

Fool contributor Tim Beyers writes weekly about personal finance and investing basics. Have a Foolish money tip? Tell him. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. Find his portfolio here and his latest blog commentary here. The Motley Fool's disclosure policy is lobbying its local school district for a course in beginning mathanese.