A key question looming on the minds of dividend investors
and the stock market in general surrounds the taxation of dividends in 2011.
By way of context, dividends are taxed at the corporate level – as income, as well as at the individual level. This results in double taxation, and has long been fodder for philosophical debate over the fairness of the system. One school of thought holds that individuals should not pay taxes on dividends at all, because they’ve already paid as partial owners of the companies in question.
In 2003, President
Bush signed a tax reform bill into law that brought the dividend tax rates down
from the standard wage tax rate. For
“qualified” dividends, taxes were paid at a rate of either 5% or 15%. Lower income taxpayers saw qualified dividend
rates drop to 0% in 2008-2010. This rate
structure mimics the long-term capital gains rates. Note: qualified dividends are paid on stocks held
for all of the 120 day period around the ex-dividend date, which is the date on
which the shareholder base is determined with regard to who will receive
dividends. In other words, if a
shareholder owns the stock on or before ex-dividend date, he or she will
receive a dividend for that period.
The 2003 cuts were significant, as the top tax bracket had
dividend taxes cut from 35% to 15%.
Perhaps more importantly, the two lower brackets dropped from 10%/15% to
not paying any taxes on dividends.
Unfortunately, the dividend tax rate is set to expire beginning January
1, 2011. At that point, taxes on dividends will revert to the rates paid on
wages. Right now it is unclear what will
actually happen at that point, however.
Simply extending the lower dividend rate seems like an
option. However, that would be considered
a tax cut, which would require Congress to justify under PAYGO rules. In short, the higher rates are factored into
our federal revenue projections, and we’d have to pay for lower rates – even in
the case of an extension – by cutting spending or raising revenue somewhere
Undoubtedly, any plan to raise taxes on dividends is
designed to raise revenues to help pay for the dramatically increased
government spending that has taken place over the last decade. However, in its most extreme form, an
unintended consequence could be to weaken the balance sheets of US
corporations, such that they are less well equipped to deal with economic
downturns. That is because raising taxes
on dividends could incent corporations to use debt instead of equity. At least, it may dis-incent them to use
equity, as the tax would be the same on interest payments as on dividends.
Furthermore, the recent health care bill already includes an
additional 3.8% tax on investment income beginning in 2013. This includes dividends. So the rate is going up, one way or another.
What makes this a particularly stick situation is that the
dividend tax decision impacts the wealthy as well as lower-income
taxpayers. Per a Wall Street Journal report, the Tax Policy
Center estimates that six million lower-income households will return to paying
taxes if the Bush administration changes are simply allowed to lapse. Most Republicans, many Democrats, and
President Obama have all stated that they believe dividends should be taxes at the lower capital gains rate, rather than standard income tax rates.
It is still anybody's guess as to how this will play out for taxpayers. How will it play out for investors? Certainly, dividend stocks are more
attractive under the current taxation plan than they were when dividends were
taxed at the standard income rates.
However, the outsized returns achieved by dividend stocks that I highlighted in a previous blog post were were largely gained under non-preferential tax rates. Consequently, the argument for dividend stocks outperforming the market over the long-term remains strong, regardless of the direction of dividend taxes. Within reason, of course.