More on the New, Lower Tax Rates on Stock Dividends

Dear Readers,
I've received quite a few questions about exactly what types of stock dividends get the new lower tax rate of 15 percent -- so this week I decided to tackle them in Q&A format.

Dear Gail,

I'm retired, so I have most of my money in investments that pay income. I read your recent column about the new tax act signed by President Bush and was wondering if you could clarify something for me about the new 15% rate on corporate dividends.

Does this include preferred stock? What about bonds that can be converted into stock? I also get dividends from a REIT- what's the tax on this? And, I have several mutual funds that send me a 1099 each year showing the dividends that they paid me. Will I pay the lower tax rate on these as well? Oh, and what about the dividends I received this year before this legislation was passed?

Thanks,

David

Dear David --

It always takes some time to sort out the practical side of a major piece of new legislation -- and since I can only give a general explanation, readers should always consult with their own tax advisors for specific details. However, as you mention, thanks to the Jobs Growth and Tax Relief Reconciliation Act, investors who receive stock dividends will get a big -- albeit temporary -- tax break: instead of being taxed at their ordinary income tax rate on these dividends, the maximum tax will be 15%.

Individuals in the 10% or 15% income tax brackets get an even bigger break. For them, dividend income will be taxed at a maximum of 5% through 2007 and 0% on in 2008. And to answer your last question first, this Act is retroactive to the first of this year so the dividends you've already received are affected.

The lower tax rate on dividends sounded pretty straightforward until people started thinking about the kinds of issues you raise. For instance, what about the income from so-called "hybrid" investments such as convertible bonds, which, as their name implies, give the owner the right to exchange the bonds for shares of stock?

The easiest way to keep this straight is to remember that tax rate you'll pay on the income from your various investments depends upon the source of that income -- regardless what it's called. Only true dividends paid by corporate stocks (as opposed to mutual fund dividends, which we will get to in a minute) are affected by the new rules and get the lower tax rate.

Income that is paid by bank accounts and debt instruments such as CDs, bonds, notes is considered "interest." Under this legislation, it will continue to be taxed at ordinary income tax rates, which could be as high as 35% (federal) starting July 1. This includes convertible bonds. The Treasury Department's Andrew Lyon, says if and when such a bond is actually converted to shares of stock, then any income paid will be considered a "dividend" and receive the new, preferential rate of 15%.

Since most preferred stocks pay a fixed income, they can seem more like a debt security than a stock. Nevertheless, the income from preferred stocks is generally considered a "dividend," and is entitled to the lower 15% tax rate.

But you've got to be careful if you own preferreds. According to Lyon, who is Deputy Assistant Secretary for Tax Analysis, some preferred securities are treated as equities for corporate bookkeeping purposes, but allow the company to take a deduction for paying interest when they compute their corporate taxes. (Don't worry, this is all perfectly legitimate.) In that case, the preferred you own is really a debt instrument and is not entitled to the lower dividend tax rate.

If you're invested in preferreds through mutual funds, they'll sort this out for you on your annual 1099 form. If you own individual preferred securities and aren't sure which tax rate applies, you need to check with the companies that issued them.

Although some of the larger real estate investment trusts trade on a securities exchange, a REIT is not a stock. Its income usually comes exclusively from rents and lease payments on the properties it owns. But in rare cases, in addition to property, REITs invest some of their assets in real estate-related stocks, such as shares of Fannie Mae. If this is the case, the income the REIT earns from stock dividends and passes through to investors would be taxed at 15%.

A related issue concerns limited partnerships. By definition, a limited partnership cannot issue stock. Even if it trades on a "stock exchange," income from a limited partnership can never be a dividend. It will always be taxed as ordinary income.

Now, about mutual funds. While all payments from mutual funds are considered "dividends," when it comes to taxes, these distributions have always been broken down to reflect the portion that came from capital gains/losses and the amount received as income. Thanks to this new law, the "income" portion will have to be further separated into "interest" income from bonds and "dividend" income from stocks. Don't worry -- your mutual fund will do this for you.

Thus, income your mutual fund receives in the form of "interest" will continue to be taxed at ordinary income tax rates. Income that comes from long-term capital gains or from true stock dividends, receives the 15% rate -- at least through the end of 2008!

Hope this helps,

Gail

Dear Gail,

I'm a big believer in diversification, so I have a portion of my retirement money invested in foreign stocks through a couple of international mutual funds. But with this new break on corporate dividends, I'm thinking that I'd be better off moving my stock investments back home, i.e. all U.S. companies. Is this a good idea?

Thanks,

Jeanne

Dear Jeanne-

The good news is you can benefit from the new 15% tax rate on stock dividends and not have to change your asset allocation at all!

According to the U.S. Treasury Department , this tax break also applies to dividends paid by foreign stocks, provided one of the following is true: 1) the foreign stock also trades on a U.S. securities exchange, or 2) the issuing corporation is headquartered in a country that the United States has an income tax treaty with. This includes virtually all developed nations.

Unless your international stocks are in companies located in obscure or emerging countries where we have no treaty, the maximum tax on the dividends they pay will be 15%.

"Vive l'Egalite!", as they say.

All the best,

Gail

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