- Historically, dividends were always treated as short-term capital gains and were subject to the marginal tax rate of the individual receiving them. That is, if the tax payer owed 15 percent on his earned income, he was required to pay 15 percent on all dividends as well. Similarly, someone in the 35 percent tax bracket had to pay 35 percent on dividends as well. However, with the passage of the Jobs and Growth Tax Relief Act of 2003, qualifications for special tax treatment of some dividend payments were developed.
- The following requirements must be met in order for dividend payments to be deemed eligible for special tax treatment. They must be paid by a U.S. corporation, a corporation incorporated in a U.S. possession or by a foreign corporation located in a country that is eligible for benefits under a U.S. tax treaty that meets certain criteria, or on a foreign corporation's stock that can be readily traded on an established U.S. stock market (e.g., an American Depositary Receipt or ADR). Dividends must have been paid out between the beginning of 2003 and the end of 2010, and they must have been held for at least 61 days of the 120-day period beginning 60 days before the ex-dividend date and ending 59 days after the ex-dividend date.
- Dividends were formerly regarded as short-term capital gains. Long-term capital gains, however, were subject to lower rates of taxation. Since 2003, qualified dividends are taxed as long-term capital gains, thus enjoying some tax advantages. While more affluent tax payers will still pay a higher tax rate on qualified dividends, it is a lower rate than that on their ordinary income. For example, a person in the 28 percent tax bracket will only pay 15 percent on qualified dividends while someone with a marginal tax rate of 10 percent may pay as little as 0 percent on qualified dividends.
- The 2003 Jobs and Growth Tax Relief Act may expire at the end of 2010. While it can be extended by legislation, as of June 2010, no such legislation is pending. At its expiration, all dividends will return to the status of short-term capital gains and subject to taxation at the normal marginal tax rate of the recipient. While the tax code changes frequently, this will likely be the case for 2011 as tax changes are seldom retroactive.
- As these changes become effective (or expire), it may be advisable to re-balance the mixture of various instruments in your investment portfolio. Remember, however, that there are myriad factors besides tax treatment to consider. Risk, liquidity, long-term goals and your investment horizon are all important variables. Plan carefully and consult a professional before making any major decisions.
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