MONEY MANAGEMENTFrom the Virginia Society of Certified Public Accountants - Presented by Dean Knepper, CPA, CFP®
UNDERSTANDING HOW DIVIDENDS ARE TAXED
(September 23, 2005) — It’s been a few years since the Jobs and Growth Tax Relief and Reconciliation Act of 2003 changed how dividends are taxed. As a result of that tax law change, investors now pay lower tax rates on certain qualifying dividends. The Virginia Society of CPAs offers the following refresher on the taxation of dividends, along with some advice for investors.
2003 Act lowered dividend tax rate
Prior to the 2003 Tax Act, dividends were taxed the same as other items of ordinary income, which could be as high as 35 percent. Effective January 1, 2003, the maximum tax rate on qualifying dividends dropped to 15 percent for most taxpayers. For those in the 10 or 15 percent brackets, the current tax on dividends is 5 percent and drops to 0 percent for 2008. Unless Congress acts to extend these tax benefits, the pre-2003 tax rates and rules return in 2009.
Not all dividends qualify
To qualify for the lower tax rate, the dividends you receive must be from a domestic corporation or a qualified foreign corporation. A qualified foreign corporation is one that is traded on an established U.S. Securities Market, incorporated in a U.S. possession or is eligible for benefits of a comprehensive income tax treaty with the U.S. The reduced tax rates do not apply to other corporations.
Not eligible for the tax rate reduction are dividends paid by corporations such as credit unions, mutual savings banks and savings and loan associations, and dividends credited to policyholders from an insurance company. Income paid by bank accounts and bank certificates of deposit is considered interest — not dividends — and interest continues to be taxed at ordinary income tax rates.
Dividends received by stock mutual funds and passed through to individual investors should generally qualify for the 15 percent rate. If you invest in mutual funds, your year-end Form 1099 will indicate what portion of the income you received during the tax year is eligible for the lower dividend tax rate.
A holding period applies
To qualify for the lower dividend tax rate, you must hold a share of common stock for at least 60 days during the 121-day period beginning 60 days before the ex-dividend date. The ex-dividend date is the date selected by a company as of which the purchaser of the stock does not receive any declared but unpaid dividend. So, for example, if you buy a dividend-paying stock one day before the ex-dividend date, you will get the dividend.
Lower dividend rate and your investment strategy
Dividends earned on stocks held in 401(k)s, IRAs and other qualified retirement plans are not taxed when earned. In most cases, however, distributions from these accounts are taxed as ordinary income. (No taxes are imposed on distributions from a Roth IRA.) As a result, it may make more sense to hold stocks outside of tax-deferred retirement accounts. Again, remember to factor into your decision the scheduled expiration date for the 15 percent tax rate.
Keep in mind, too, now that the after-tax return on dividend-paying stock is lower, tax-exempt bonds may offer less of a benefit. Investors should be forewarned, however, that the lower dividend tax rate is set to expire in 2009.
CPAs also caution taxpayers not to load up on stocks just to get the tax benefit. Every investment you make should be in alignment with your financial goals, asset allocation and diversification strategies, and your tolerance for risk. If you have any questions about how the taxation of dividends impacts your overall financial planning, consult with a CPA.
The Virginia Society of CPAs is the leading professional association dedicated to enhancing the success of all CPAs and their profession by communicating information and vision, promoting professionalism, and advocating members’ interests. Founded in 1909, the Society has nearly 8,000 members who work in public accounting, industry, government and education. This Money Management column and other financial news articles can be found in the Press Room on the VSCPA Web site at www.vscpa.com.
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