If you've ever read somewhere that dividends are taxed twice and have wondered whether it's true, you can rest assured that it is. Sorry.
Consider Spray-On Socks Inc. (ticker: PFFFT). Let's say it rakes in $100 million in sales one year and, after subtracting expenses, retains $20 million as its operating profit. Well, Uncle Sam doesn't just pat the company on the back. He demands his share, in taxes. Corporate income tax rates can reach 35% or higher. So perhaps $13 million will remain after taxes as net profit.
The firm can do many things with that money. It can buy back some of its own shares (increasing the value of remaining shares), pay down debt, build more factories, hire more workers, acquire other companies, and so on. If it pays out some of these earnings as dividends to shareholders, though, the shareholders will recognize the dividends as income. That means Uncle Sam will claim a chunk of that personal income in taxes. Ugh. That money has now been taxed twice -- once on the company's tax return and once on the shareholder's tax return.
This is one reason why investors might prefer to see a company using its money to build more value for shareholders without paying out dividends. It's also why some companies are reducing dividends, opting instead to repurchase shares and reward shareholders in a tax-free way.
On the other hand, many investors value dividends, since they represent the proverbial "bird in the hand." Some studies have suggested that dividend-paying companies outperform non-payers over the long run. Plus, many folks appreciate the income that a solid dividend can provide. (If you're such a person, check out Motley Fool Income Investor.)
The (relatively) good news is that the rate at which dividends are taxed has been lowered. They used to be taxed at the investor's marginal rate (better known as the tax bracket), which is 25% for most people, but can be as high as 35%. But beginning last year, the maximum tax rate on qualifying dividends was dropped to 15% for most folks. For those in the 15% or 10% bracket, qualifying dividends will be subject to a maximum tax of only 5%.
So don't avoid dividends just because of the tax hit, especially if your dividend-paying investments are in a tax-advantaged account such as an IRA. But take the after-tax return into account. After all, it's not what you earn that counts -- it's what you keep.
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