One of the provisions of the recently passed Jobs and Growth Tax Relief Reconciliation Act of 2003 included changes in how dividends are taxed. Investors will now pay lower tax rates on dividends received from domestic corporations and qualified foreign corporations.
In the past, dividend income was just another source of ordinary income, taxed at your normal tax rate, which could be as much as 35%. No longer. Beginning in 2003 the maximum tax rate on qualifying dividends has been dropped to 15% for most people. And for those of you in the 15% or 10% bracket, qualifying dividends will be subject to a maximum tax of only 5%.
Seems simple, right? Well, it's not as simple as you might think.
Holding period
In order to qualify for the new lower taxes on dividends, you're required to hold the stock on which the dividends are paid for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date. The ex-dividend date is the last date on which a shareholder of record is entitled to receive the upcoming dividend.
So if you're thinking about "trading" dividend-paying shares in an attempt to simply secure a dividend and have that dividend taxed at a lower rate, don't bother. The holding period rules will simply render your dividends as nothing more than regular income taxed at your normal tax rate.
Will the company tell you if your dividends are qualified? Nope. It'll be your responsibility to determine if any (or all) of the dividends received will qualify for the lower tax rate. This will mean even more record keeping on your part, so be forewarned.
Qualifying dividend income
In order to receive the lower tax rate, the dividends must be received from a domestic corporation or a qualified foreign corporation. A qualified foreign corporation is one that is incorporated in a U.S. possession or is incorporated in a country that has a current tax treaty with the U.S. and meets various other qualifications.
So if you're invested in a foreign corporation that pays dividends, make sure that this corporation will be treated as a qualifying foreign corporation. Take the matter up with the shareholder relations folks at the corporation. They would certainly know if they'd be treated as a qualified foreign corporation.
Not all dividends are created equal
Just because a check is accompanied by a document with the word "dividend" doesn't mean that the money qualifies for the lower dividend tax rate. For example, dividends credited to policyholders by insurance companies aren't qualifying dividends. Neither are patronage dividends paid by cooperatives to their patrons.
There are other dividends that will also not qualify for the reduced tax rates:
- Dividends paid to the extent that the taxpayer is under an obligation to make a related payment on a position in substantially similar or related property. You'll usually (but not exclusively) see this pop up on dividend payments on short sales.
- Dividends that the taxpayer elects to take into account as investment income. Why would you make such an election? Perhaps to generate investment income in order to deduct investment expenses.
- Dividends received from a corporation exempt from tax under Code Section 501, such as charitable, religious, and scientific organizations
- Any amount allowed as a deduction for dividends paid by a mutual savings bank
- Dividends paid and held by an employee stock plan (ESOP)
Mutual funds
Special rules apply to a regulated investment company (the technical name for a mutual fund). If the fund receives qualifying dividends from stock that it holds, and passes those dividends to you (the shareholder), you'll be able to apply the new, lower rates to those dividends. But this is going to be a tricky proposition for the mutual fund companies.
You'll (ideally) see the mutual funds reporting information differently to you at the end of the year. Instead of the old reporting of regular dividends (which included dividends, interest, and short-term gains) and long-term capital gains, the mutual fund companies will now have to report a completely separate source of pass-through income: qualifying dividends available for the lower dividend rates.
Sunset provisions
As with virtually all of the provisions of the 2003 tax act, the lower tax rates on dividend income will expire at the end of 2008. That means, unless made permanent by some future Congress, these new provisions will fade into the sunset, and the rules on the taxation of dividends will revert back to the old rules (ordinary income taxed at your normal tax rate).
So make sure that your dividends qualify for the new, lower tax rates. You'll have some additional work and record-keeping, but your tax savings will be worth the effort. If you don't think so, take a look at Jeff Fischer's article on this very subject.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
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