What's Up With Dividends?

Tax Article

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What's Up With Dividends?
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
June 13, 2003

Updated on May 11, 2006 to include new 2006 tax law changes.

We covered the big picture for the new JGTRRA (Jobs and Growth Tax Relief Reconciliation Act of 2003) in Tax Cut Pays Big Dividends. To recap, the federal tax rate on long-term capital gains is now 15 percent instead of 20 percent for sales on or after May 6, 2003. That's also the new tax rate for dividends—formerly taxed as ordinary income—retroactive to Jan. 1, 2003.¹ Federal income tax brackets went down as well.

However, some dividends don't qualify for the new rate. And what about mutual fund distributions? Finally, should you change your strategy in light of the new rules?

All dividends are not created equal
"Qualified" stock dividends—which include nearly all common stock dividends—are eligible for the new 15 percent rate. Your 2003 Form 1099 should categorize your investment income properly.

However, for planning purposes, here's a list of dividends that DON'T qualify for the new rate—they're taxable as ordinary income.

Certain preferred stock dividends. Most preferred stock is structured as debt to receive an interest expense deduction at the corporate level. However, many companies are expected to restructure their preferred stock or issue new preferred stock to qualify for the 15 percent dividend tax. Check with your broker on a company-by-company basis.
Real estate investment trust dividends. Because REITs are typically tax exempt at the corporate level, the dividends they pay generally won't qualify. Distributions in the form of long-term capital gains, however, will receive the 15 percent rate.
Certain foreign stock dividends. Dividends from foreign stocks traded as American Depositary Receipts on a U.S. exchange will qualify. The 15 percent rate should also apply to foreign companies based in U.S. territories (such as Puerto Rico or Guam), as well as to companies traded in a foreign country that has an established tax treaty with the United States. Other foreign stock dividends will be subject to ordinary income tax.

What about mutual fund dividends?
Mutual funds call all sorts of things "dividends," including interest income from bonds and money market funds. Going forward, mutual fund companies will likely use these three categories to report your investment income on Form 1099:

Ordinary dividends. Ordinary dividends are taxed at your regular income tax rate. These include interest dividends from bonds and money markets, non-qualified stock dividends, most REIT dividends, and short-term capital gains.
Qualified dividends. Qualified stock dividends will be taxed at 15 percent or 5 percent, depending on your tax bracket.
Capital gain distributions. Long-term capital gain distributions will be taxed at 15 percent or 5 percent, depending on your tax bracket. (In 2003 only, long-term gains may be split into two categories—gains realized on or after May 6, 2003 get the new rate, but gains realized prior to that will be taxed at the old rates of 20 percent or 10 percent, depending on your tax bracket.)

The fine print

To qualify for the special tax rate, you or your mutual fund must have held the stock for more than 60 of the 121 days surrounding the "ex-dividend" date. The 121-day period starts 60 days before the stock goes ex-dividend.
Qualified dividends that receive the 15 percent rate aren't considered “investment income” for purposes of the investment interest expense deduction (although you can elect to treat them as ordinary income to offset the interest expense).
If you borrow to buy stocks on margin and your broker lends out your stock, you don't really receive dividends, you receive "payment in lieu of dividends." Such payments are treated as ordinary income and aren't eligible for the lower rate.

Should you change your strategy?
In light of the new tax rates, what, if anything, should you do differently? First, don't let the tax tail wag the dog—there's likely no reason to dramatically change your portfolio. For many, the new rates simply mean your overall tax bill goes down.

That said, here are a few situations to watch for:

Bonds or dividend-paying stocks?
Considering a switch from bonds to dividend-paying stocks? Be careful—stocks are an entirely different asset class and carry their own risks.

However, if you find you have more bonds than you'd like in taxable accounts, you might consider selling some and using the proceeds to buy a diversified group of highly rated, dividend-paying stocks (log in for Schwab's stock screener).

For example, at the highest ordinary income tax bracket, a highly rated taxable bond paying 4 percent would leave you with only 2.6 percent after taxes. But a mix of highly rated stocks paying an average current qualified dividend yield of 4 percent would leave you with 3.4 percent after taxes.

Mutual fund investors may wish to consider stock funds geared more toward current dividend income, such as the American Century Equity Income fund (TWEIX) or Parnassus Equity Income fund (PRBLX) (click here for Schwab’s OneSource Mutual Fund Select List).

Always evaluate your decision in the context of your investing goals, your asset allocation and your ability to sustain losses.

Gifting
If you have a family member who's 18 or older, think about gifting securities that you've held over a year (up to $11,000 per year, or $22,000 for spouses "splitting" gifts with no gift tax, as of 2003). Under the "kiddie tax" rules, kids 18 and older are taxed at their own rate, not yours. If they’re in the 15 percent ordinary income bracket or lower, they'll pay only 5 percent in long-term capital gains tax vs. the 15 percent you would pay if you sold the securities and gave them the cash.

Likewise, dividend-paying stocks held for income could make tax-smart gifts. If a child 18 or older holds the stock and receives the dividends, he or she will likely pay only 5 percent on the income. What's more, that 5 percent rate goes to zero after 2007 for both long-term gains and dividends.¹
Dividends in taxable vs. tax-deferred accounts
The lower capital gains and dividend rate makes managing investments for tax efficiency even more advantageous. Here's why: If you hold long-term investments in taxable accounts, you'll typically pay long-term capital gains tax when you sell. But if you hold those same investments in a tax-deferred account, such as a traditional IRA, any gain will eventually be taxed as ordinary income—typically a higher rate.

The new law doesn't significantly change this tax-smart strategy for investors in top tax brackets, while middle-income investors gain more of an edge:

The spread between ordinary tax rates and capital gains rates is little-changed
	Pre-2001	New law
Top income tax rate	39.6%	35%
Long-term capital gains rate	20%	15%
Difference	19.6%	20%
Middle income tax rate	28%	25%
Long-term capital gains rate	20%	15%
Difference	8%	10%

But here's the big news: The spread between ordinary rates and the new dividend rate is significant for just about everybody. Previously, it might have made sense to hold dividend-paying stocks in your IRA instead of your taxable accounts, because the dividends were taxed at your ordinary income tax rate anyway. Now, with dividends taxed at 15 percent (or 5 percent, depending on your bracket), the value of putting dividend-paying stocks in taxable accounts has grown tremendously.

Dividend tax has changed significantly
	Dividend tax pre-2001	Dividend tax now	Difference
Investor in highest tax bracket	39.6%	15%	24.6%
Investor in middle tax bracket	28%	15%	13%

Do the new rules make tax-deferred accounts unattractive? Absolutely not! It simply means that where you place your investments is more important than ever.

Where tax-smart investors put their investments
Taxable accounts	Tax-deferred accounts such as traditional IRAs, 401(k)s and deferred annuities
Individual stocks held over one year	Individual stocks held one year or less (when sold for a gain)
Tax-managed stock funds, index funds, low-turnover stock funds	Actively managed funds that generate significant short-term capital gains
Stocks or mutual funds that pay "qualified" stock dividends²	Taxable bond funds, zero-coupon or TIP Treasury bond funds, high-yield bond funds⁴
Municipal bonds³	Real Estate Investment Trusts

Remember, at the end of the day, it's after-tax dollars that count. Be a tax-smart investor and take advantage of the new tax law. Be sure to consult an investment professional to find out what makes sense for you before you take action.

1. A special 5 percent long-term capital gains and dividend tax rate applies to taxpayers below the 25 percent bracket, with that rate going to zero after 2007. Unless Congress extends the law, the new capital gain and dividend rates expire after 2010 and pre-2003 law will apply.

2. All things being equal with respect to turnover and assuming an ordinary tax bracket of 25 percent or higher.

3. For those in higher ordinary income tax brackets, depending on tax-equivalent yield comparisons.

4. Treasury securities are exempt from state income tax.

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 1-800-435-4000. Please read the prospectus carefully before investing.

Investments in high-yield bond funds are subject to greater risk of loss of principal and interest than other bond funds. Purchasers should carefully assess the risks associated with an investment in this fund.

Stock and mutual fund values and returns fluctuate, and they carry no obligation to return a particular value at a particular date.

The information and content provided herein is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based on this information.

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