Tax reform bills have passed both the House and the Senate, and a joint conference is working to try to reconcile the two measures and come up with a compromise solution that both chambers of Congress can pass. One area where the two bills largely agree is in the way investors get taxed on dividends and capital gains, but the way that the rest of the reform provisions interact with investment-related taxation could make things more complicated rather than less for taxpayers with investment income.
How tax reform would treat dividend and capital gains income
Under current law, investors pay preferential rates on qualified dividends and long-term capital gains. If you're in the existing 10% or 15% brackets, then you'll pay a 0% rate. Those in the 25% to 35% brackets pay a maximum of 15% on their qualified dividends and long-term capital gains, while those in the 39.6% bracket pay a 20% maximum tax on that investment income.
The House measure sought to simplify the tax structure by putting in new brackets of 12%, 25%, 35%, and 39.6%. Yet the House would maintain the 15% and 20% maximum rates on qualified dividends and capital gain, with those in the 12% bracket paying nothing, those in the 25% and 35% brackets paying 15%, and those in the top bracket paying 20%. That effectively leaves taxpayers facing six different rates that can apply to various types of income, which is slightly less than what they have to deal with under current law.
The Senate plan gets even more complicated. With its new brackets of 10%, 12%, 22.5%, 25%, 32.5%, 35%, and 38.5%, the Senate version would have investors pay 0% if they were in the first two brackets, 15% if they were in any of the next four brackets, and 20% if they were in the top bracket. That adds up to nine different tax rates that investors have to keep in mind if they anticipate having dividend or long-term capital gains income.
Expect even longer worksheets
For those looking for simpler tax preparation, the way that tax reform deals with dividend and long-term capital gains income doesn't really do a good job of achieving that goal. Under the old law, most taxpayers either paid no tax on dividends and capital gains or paid 15%, which was a tax rate they were already quite familiar with paying for some of their ordinary income. Indeed, the 20% dividend and capital gains rate on high-income taxpayers came about only as an add-on in the changes made during the infamous fiscal cliff period. Before that, a 15% maximum applied across the board.
Now, taxpayers with dividend income or long-term capital gains income will face an even longer set of calculations involving more potential tax rates. That will make calculating the appropriate tax more complicated, raising the chances of math errors or confusion about which rates apply to which types of income for taxpayers in various brackets. That's an ironic change, given the stated desire from lawmakers to make things easier on the general public.
Better than the alternative
As much as investors won't like more complicated tax returns, preserving the preferential rates for dividend and long-term capital gains income is better than what lawmakers could have done. It would have been possible for Congress to unify the rates for all investment income, forcing dividend investors to pay ordinary income tax rates on the payments they receive just like those who receive interest income have to do. This measure at least preserves the current tax break.
There's always the possibility that lawmakers will come up with another change that affects those who have long-term capital gains or qualified dividend income differently from how the current proposals do. Taxpayers should nevertheless prepare themselves to deal with new challenges come 2018 if tax reform passes.
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