This week, Gail explains how to make sure your stock dividends qualify for lower tax rates.

 

Dear Gail,

Is income from ADRs, e.g. British Petroleum, a beneficiary of the tax relief for dividends?

Bernie

 

Dear Bernie,

Yes. Now, for those who are wondering what you're talking about allow me to explain...

The "Jobs and Growth Tax Relief Reconciliation Action of 2003" (a.k.a. "JGTRRA") contained a number of provisions designed to put more money into consumers' pockets and, thus, stimulate spending to get the economy humming again. The particular section you're referring to was aimed at making it more attractive to invest in stocks and, thereby, boost the stock market.

Many feel these tax breaks partly contributed to the 28.7-percent total return the S&P 500 Index posted last year.

There are two tax breaks that directly benefit investors: 1) a reduction in the capital gains tax; and 2) a significant decrease in the tax rate on stock dividends.

Prior to passage of this Act, the two tax rates on long-term capital gains were 10 percent (for those in the two lowest income tax brackets) and 20 percent (for everyone else). JGTRRA reduced these to 5 percent and 15 percent, respectively. For those in the top tax bracket, that represents a 25 percent reduction in the amount of tax they have to pay when they sell an asset at a profit.

In 2008, folks who qualify for the lowest bracket will not have to pay any capital gains tax. Starting in 2009, we revert back to the capital gains rates previously in effect.

JGTRRA also drastically reduced the amount of tax you have to pay on "qualified" stock dividends. Instead of dividends being considered "current income" and, thus, taxed at your ordinary income tax rate — which could be as high as 35 percent — through 2008 the same tax rates will apply to dividends that apply to long-term capital gains.

For someone in the 10 percent or 15 percent income tax bracket, this means they only have to pay a 5 percent tax on dividend income. In 2008, this drops to 0 percent. Everyone else will still pay a maximum of 15 percent. If you're in the 30 percent or 35 percent tax brackets, this is at least 50 percent less tax than under the old rules. But this, too, is temporary. In 2009 we're back to taxing stock dividends as ordinary income.

As I wrote when this law was passed last year, not all "dividends" qualify for this temporary tax break. Those that DO include:

1. Dividends paid on common or preferred stock issued by a U.S. corporation

2. Dividends paid on the stock of a foreign corporation if:

— the firm is headquartered in a country with which the U.S. has a "comprehensive" tax treaty, or

— the firm's shares trade on a U.S. stock exchange.

This includes ADRs, or American Depositary Receipts. These are a convenient way for American investors to buy stock in a foreign company without having to go through a stock exchange in that company's home country. As the name implies, they are a "receipt" for shares of stock in the foreign corporation which are actually held on your behalf by an American bank overseas. So, instead of having to find a broker in Tokyo who will help you buy shares of say, Toyota, on the Tokyo stock exchange, you can simply purchase Toyota's ADRs on the New York Stock Exchange through your U.S. broker.

There is one additional requirement you have to meet in order to qualify for the lower tax on stock dividends: a minimum "holding period." For common stocks, you have to own the shares fore more than 60 days out of the 121 day period that begins 60 days before the "ex-dividend" date.

Huh?!

The "ex-dividend" date is the date the stock begins trading without the dividend. If you invest in the stock on or after the day it goes "ex", you're buying the stock without the privilege of receiving the dividend.

Let's say the Board of Directors for XYZ, Incorporated decides to pay a dividend of $1.00 per share. The checks will be sent on December 20. To determine which investors will receive a dividend check, the board sets the "Date of Record" as November 15. All investors who are "on record" as owning the stock on that date are entitled to receive the dividend.

This means if you buy the stock on November 16, you are buying it minus the dividend, hence the term "ex-dividend date." Even if you own the stock on December 20, you will not receive a dividend check because you were not an owner as of the Date of Record.

To qualify for the tax break on stock dividends, you have to own the stock for at least 61 days, counting the days both before and after the ex-dividend date. Not to add to the confusion, but the date you bought the stock does not count toward the total, whereas the date you sold it does.

In the above example, if you bought XYZ stock on September 16 and sold it on November 16 (the day it goes ex-dividend), you would be eligible to receive the dividends (because you were a shareholder on the Date of Record) and you would qualify for the reduced tax rate of either 5 percent or 15 percent because you owned your shares for a total of 61 days — 60 days before the ex-dividend date, plus that day (your selling date).

It helps if you look at a time line:

Sept. 16: purchase stock

Sept. 17: Day 1 of ownership

Nov. 15: Date of Record

Nov. 16: Ex-dividend Date & Day 61 of ownership. Stock sold

Dec. 20: Dividend Paid

In this example, from the standpoint of the I.R.S., your "holding period" begins September 17 and runs through November 16. Exactly 61 days. (Be careful! Be sure you count the actual number of days each month has. In this case, September has 30 days, but October has 31.)

If you were to invest in this stock AFTER September 16, you would have to extend the date for selling accordingly in order to qualify for the reduced tax rate.

What if you bought the stock on the Date of Record, the day before it went ex-dividend? In this case, to qualify for the special dividend tax rate you'd want to wait until at least January 15 to sell it. According to Don

Roberts in the I.R.S. Press Office, the simplest way to look at this is as follows: "If you received the stock dividend and you own the stock more than 60 days, then the holding period requirement will automatically be met." (Whew!)

The holding period for preferred stock is 91 out of 181 days around the ex-dividend date. The same approach applies.

If you're a buy-and hold investor, this probably isn't something you need to worry about. But day-traders are out of luck.

Investing in stocks via mutual funds takes all the guesswork out of the process because the mutual fund will provide you with a statement at the end of the year that breaks down all of the income you earned based on long and short-term capital gains, "qualified" dividends, and ordinary income.

Hope this helps!

Gail

 

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