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Investor's Guide to the Dividend Tax

How the Dividend Tax Works and the Dividend Tax Rates

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Dividend Tax Rates

Dividend tax rates are set relative to your personal income tax rate. Currently, the dividend tax rate is set at the same level of long-term capital gains tax rates, but this is set to expire in 2011 when they will revert to ordinary income tax rates.

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The dividend tax is one of the most common investment taxes paid investors, whether you own 100 shares of Johnson & Johnson or 1,000,000 shares of McDonald's. The rules on how the dividend tax works and specific dividend tax rates, however, are not very well understood. This guide was put together to help you understand the basics. Given the importance of cash dividends for income oriented investors, it was meant to serve as an augment to the special step-by-step Dividends 101 - Your Complete Introduction to Dividends and The Ultimate Guide to Dividends and Dividend Investing.

The Dividend Tax 101

In the United States, dividend income is classified as any taxable distributions that are not treated as a long-term capital gain. For most people, the dividend tax is commonly paid on distributions made from regular C corporations to their stockholders. Virtually all shares of stock traded through your stock broker are going to be of this variety. The dividends are not tax-deductible to the corporation, as they are in many other countries, thus introducing severe criticism from some corner that the United States is one of the few nations that penalizes investment through the double taxation of dividends.

Dividend Tax Rates By Type

When it comes to the dividend tax there are several categories into which each dividend payment may fall. The dividend tax rules are spelled out in IRS Publication 550.:

  • Qualified Dividends: For the purposes of calculating the dividend tax, ordinary dividends are for stocks held more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. These are taxed at what is known as the qualified dividend tax rate, which is 5% or 15% depending upon the income tax bracket into which the investor falls. For investors with personal income tax brackets of 25% or higher, they will pay a 15% dividend tax on their qualified dividends. For investors in a lower income tax bracket, they will pay a 5% dividend tax. Qualified dividends must be paid between January 1, 2003 and December 31, 2010.
  • Non-Qualified Dividends: A non-qualified dividend is any dividend that doesn't meet the test of qualified dividends (see above). The dividend tax on these dividends is the same as an investor's personal income tax bracket. If you're in the 35% tax bracket, for instance, you'll pay a 35% dividend tax on non-qualified dividends.

Sunset of Dividend Tax Relief Scheduled for January 1st, 2011

Under the current dividend tax law, so-called qualified dividends will no longer be taxed at the same rate of long-term capital gains, but instead revert to individual tax rates.

For illustrative purposes, let's say you were the sole shareholder of a corporation that earned $100 million per year pre-tax. Your corporate taxes would be approximately 35%, or $35 million, leaving $65 million in net income. If you were to take all of these profits as a cash dividend, under the current system, you would owe 15%, or $9.75 million, leaving $55.25 million of your original $100 million in profit. If the dividend tax rates increase in 2011, you would owe $25.74 million, or 39.6%, leaving $39.26 million of your original profit for a total effective tax rate of 60.74%.

To get around this there are, of course, dividend tax techniques such as using an Sub-Chapter S Corporation or a Limited Liability Company with pass-through taxation. In those cases, there would be no dividend tax because you would pay personal income taxes on your $100 million in profit, or 39.6% in 2011, leaving $60.4 million after tax. This is why you often see wealthy families and business owners spending large sums on accountants and lawyers. By properly structuring their affairs, a simple decision about business form can result in paying half the dividend tax rate that would otherwise be owed!

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