Dividend Tax RateDividend tax rate continues to be a controversial topic. Let's explore some history on how dividends have been taxed and look at the current tax rate on dividends.
Dividends received on investments have, for the most part, always been treated as ordinary income when it comes to taxation. This is in sharp contrast to capital gains on the investment. The capital gains tax — the tax you pay on the increase in value of your investment — since its inception in 1954 has always been at a lower rate than the dividend tax rate. Until 2003. In 2003 the Bush Administration proposed elimination of the dividend tax. Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003, which didn't eliminate the dividend tax, but made significant cuts to the tax rate. If dividends meet certain requirements, they get classified as qualified dividends and they are treated the same as long-term capital gains. This rate is at 15% for the 25% and above income tax bracket. This Act expires at the end of 2010. What happens after that? Most experts seem to agree that the tax rate on dividends will go up for higher income households, but might remain unaffected for the rest.
When companies pay out dividends, the funds come from after-tax income. In other words, companies already pay tax on the amount that's distributed as dividends. Individuals receiving these dividends also have to pay tax on them — at the ordinary or qualified dividend rate. What's the impact of this double taxation? Consider a company that earns $10 million before tax with a tax rate of 30%. This results in a net income of $7 million. Let's say that the company decides to pay all this income out as dividends. Let's assume for simplicity that all the individuals who receive these dividends are in the 35% tax bracket. They end up paying $2.45 million in tax on these dividends. Total tax paid? $3 + 2.45 = 5.45 million. This is a staggering 54.5% effective tax rate! You can easily see why the double taxation of dividends faces a lot of opposition. Of course, we've treated the dividend above as ordinary dividends. If the dividends were treated as qualified dividends, the dividend tax would be 15% or $1.05 million, resulting in a total tax burden of $4.05 million or 40.5%. In summary, we took a brief glimpse of the history of the dividend tax rate and saw how it compared to the long-term capital gains tax rate. We covered the 2003 Act that introduced qualified dividends. Finally, we worked out the double taxation of dividends with an example. Please subscribe to our Free Newsletter for great tips on how to get started and learn to invest by yourself. Return from Dividend Tax Rate page to Dividend Investing page
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