The Jobs and Growth Tax Relief and Reconciliation Act of 2003 changed how dividends are taxed. Investors now pay lower tax rates on certain qualifying dividends.
The Pennsylvania Institute of Certified Public Accountants offers the following refresher on the taxation of dividends, along with some advice for investors.
The maximum tax rate on qualifying dividends dropped to 15 percent for most taxpayers. For those in the 10 percent or 15 percent brackets, the current tax on dividends is 5 percent, and will drop to 0 percent for 2008. Unless Congress extends these tax benefits, the pre-2003 tax rates and rules return in 2009. Prior to the 2003 Tax Act, dividends were taxed as high as 35 percent.
To qualify for the lower tax rate, the dividends 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 can be eligible for benefits of a comprehensive income-tax treaty with the United States.
The reduced tax rates do not apply to other foreign corporations.
Dividends paid by corporations such as credit unions, mutual savings banks and loan associations are not eligible for the tax-rate reduction, nor are dividends credited to policyholders from an insurance company.
Income paid by bank accounts and bank certificates of deposit is considered interest - not dividends. Interest continues to be taxed at ordinary tax rates.
Dividends received by stock mutual funds and passed through to individual investors should qualify for the 15 percent rate.
If you invest in mutual funds, the 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.
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 to when the purchaser of stock does not receive any declared but unpaid dividend.
For example, if you buy a dividend-paying stock one day before the ex-dividend date, you will get the dividend.
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. Remember to factor into your decision the scheduled expiration date for the 15 percent tax rate.
Keep in mind that the after-tax return on dividend paying stocks is lower, so tax-exempt bonds may offer less of a benefit. Investors should remember, however, that the lower dividend tax rate is set to expire in 2009.