This week, Gail addresses the effect of the new dividend tax cut on 401(k) withdrawals -- an extremely important issue for those who invest via mutual funds.

Ms. Buckner,

I have a question about the new dividend tax cut and the impact on 401(k) withdrawals.

My question is: Since 401(k)s are really tax-deferred, not tax-free, what will the tax treatment be for future 401(k) fund withdrawals with respect to that portion of the 401(k) account that may have accrued due to dividend payments?

Thank you for any insight into this matter.

Jim

 

Dear Jim -

The new 15-percent tax on qualified corporate dividend income introduced in the Jobs & Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) will have NO impact on dividends received in tax-sheltered retirement plans. Not now. Not when you withdraw the money.

Withdrawals from retirement plans are taxed at ordinary income tax rates. This law doesn't change that.

It is helpful to keep a few key points in mind. First, the tax break only applies to dividends which are taxed as current income. By definition, tax-deferred income does not qualify.

Second, 15 percent is the maximum tax rate. Folks who fall into the two lowest income tax brackets are only going to pay 5 percent tax on dividend income from now through 2007. In 2008, they will pay NO FEDERAL TAX on "qualifying" dividends. (To find out which dividends qualify, check out the column I wrote back in June.)

And please remember: the new lower tax rates on corporate dividends expire at the end of 2008 unless Congress votes to extend them.

In order to discourage people from buying a stock just to receive the dividend and then immediately selling the shares, you are required you to own the stock for a minimum amount of time in order to qualify for the lower tax rate. For common stock, the holding period is 60 out of 120 days around the date the stock trades "ex-dividend," that is, minus the dividend. ("Ex-dividend" simply means that if you buy a stock after this date, you are not entitled to receive the upcoming dividend payment.)

The holding period for preferred stock is controversial. Bright people inside and outside the Treasury Department vehemently disagree on the interpretation of this portion of the act. Greg Jenner, Deputy Assistant Secretary for Tax Policy, maintains that the holding period for preferred shares is 90 out of 180 days around the ex-dividend date. But other equally-distinguished legal minds in the private sector read the legislation as saying the holding period is the same for preferred stock as it is for common stock: 60 out of 120 days. We're going to have to wait for the Treasury Department or IRS to issue clarification on this.

If you invest in individual stocks, you (or your financial advisor) will have to maintain your own records; in case you're audited, you will need to prove you owned the stock long enough to qualify for the lower tax rate on the dividends.

If you own stocks via a mutual fund the situation is unclear. Some maintain that mutual fund investors have to meet an additional holding period over and above the one for the mutual fund. In other words, they argue that even if the mutual fund owns the stock for the required number of days and it passes the dividends paid by the stock through to shareholders, mutual fund investors would not get the benefit of the 15 percent (or lower) tax rate on these dividends unless they owned the mutual fund for a certain period of time!

What a mess that would be -- especially if you are making regular investments into the mutual fund, say monthly, using a strategy called "dollar cost averaging." Imagine if you had to try to figure out how many shares of the fund you own (and don't forget, mutual fund shares are expressed in thousandths !) that fall into the "60-out-of-120-day" period around the date the mutual fund paid a dividend?!

Clearly this is a nightmare. But it's a huge issue for the millions of individuals who own stock outside of retirement accounts.

Unfortunately, the Treasury Department does not have an answer and at this point, there's no word on when "guidance" will be issued. At the latest, we've got to have both issues resolved before the end of the year for tax purposes. Let's hope it's sooner rather than later.

Frankly, I wouldn't make major changes to the existing asset allocation of my retirement plan just because the dividends it earns don't get this tax break -- especially since the break is temporary. Stock dividends -- like the interest you receive on the bonds in your 401(k) plan -- are an important factor that can contribute to the overall growth of your retirement account. But you might want to take the tax break on dividends into consideration when you're making new investments.

Hope this helps,

Gail

 

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.