By: Richard Feldman, CFP, AIF, MBA
A clear understanding of the new reduced tax rates on dividends and long term capital gains will allow you to take advantage of these very favorable provisions. That will put more money in your pocket and leave less for Uncle Sam. Here’s a simple breakdown of the new tax law and how it works. Let’s sort out who and what qualifies for the reduced 15% / 5% rates and what actually constitutes a dividend and long-term capital gain.
The new reduced tax rates on dividends only apply to qualified dividends from corporations. Previous to the new tax law dividends were taxed at an individual’s marginal tax bracket, which could be as high as 38.6%. The highest rate on qualifying dividends is now only 15%, and only 5% for many individuals who occupy the 10% and 15% tax brackets.
To be eligible for the reduced rates on qualified dividends, you must hold the stock on which the dividends are paid for more than 60 days during the 120 day period that begins 60 days before the ex-dividend date (the day after the last day on which shareholders of record are entitled to receive an upcoming dividend payment). If you own shares for only a short time around the ex-dividend date, the dividend will constitute ordinary income and be taxed at your income tax rate rather than the 15%/5% rates.
Mutual Fund Distributions:
Many mutual funds previously lumped together dividends, short-term gains, and interest income into one category called income distributions. The reasoning was that all the above distributions were taxed at an individual’s marginal tax bracket and didn’t need to be segregated for income tax purposes because they were treated in the same manner. Mutual fund distributions will now need to be segregated due to the fact that short-term gains and interest income are not eligible for the new reduced rates on qualifying dividends.
Mutual funds that generate both qualifying and non-qualifying income carry a meaningful structural benefit. A mutual fund is permitted to offset non-qualifying income with fund expenses, leaving a proportionately larger distribution that will be taxed at the lower tax rates. Offsetting the non-qualifying income at the fund level has the effect of lowering your tax bill and is a structure that cannot be replicated at the individual level.
Capital Gains Distributions:
The new tax law provides an even greater advantage for capital gain treatment. The spread between the highest marginal tax rate at 35% and the long-term capital gains treatment of 15% is even more pronounced due to the signing of the new tax law. If your individual tax rate is greater than 15% it is important to make sure you qualify for long-term capital gains treatment. The key determinant of short term versus long-term gains is the holding period. An individuals holding period begins on the day after you acquire securities. Your holding period includes the day you sell the security. For example say you buy a stock on December 1st. Your holding period begins with December 2nd. The earliest date you can sell the stock and still maintain long-term capital gains treatment is December 2nd of the following year.
Qualified dividends and long-term capital gains earned in taxable accounts are taxed at only 5% for those in the 10% and 15% rate brackets. Your tax bracket is determined by your taxable income, which equals gross income reduced by allowable personal and dependency exemptions ($3,050 in 2003) and the standard deduction (if you don’t itemize) or the total of your itemized deductions if you do itemize. Assuming an applicable standard deduction of $9,500 in 2003, if you are married and filing jointly and have two dependent children, your gross income can be as high as $78,000 and you will still be in the 15% brackets. If you are below the above figure than your dividends and capital gains will be taxed at the 5% rate.
|10% Tax Bracket||$0 – $7,000||$0 – $14,000||$0 – $10,000||$0 – $7,000|
|15% Tax Bracket||$7,001 – $28,400||$14,001- $56,800||$10,001-$38,050||$7,001- $28,400|
|25% Tax Bracket||$28,401 – $68,800||$56,801- $114,650||$38,051- $98,250||$28,401- $57,325|
|28% Tax Bracket||$68,801 – $143,500||$114,651- $174,700||$98,251- $159,100||$57,326- $87,350|
|33% Tax Bracket||$143,501 – $311,950||$174,701- $311,950||$159,101- $311,950||$87,351- $155,975|
|35% Tax Bracket||$311,951 and over||$311,951 and over||$311,951and over||$155,976 and over|
Real Estate Investment Trusts:
Most REIT dividends will not be eligible for the 15%/5% rates. The main sources of REIT payouts are usually not qualified dividends on stock owned by the REIT. Instead, the source is usually cash flow generated by the REIT’s real estate properties. Therefore most REIT dividends paid will be taxed as ordinary income.
The new tax code provides a lot of opportunities to formulate a plan in order to take advantage of the reduced dividend and capital gain rates. Please consult with your accountant or financial advisor before making any changes. Next article I will discuss strategies in allocating investments across retirement and non-retirement accounts.