How Changes to the Tax Rate on Stock Dividends May Affect You

There are several potentially major changes to how much tax you will have to pay on stock dividends. Here is some advice that you need to consider about your investment portfolio.

Under current U.S. tax law, dividends paid to holders of U.S. corporate or publicly-traded stock are currently taxed at the same rate as long-term capital gains. This rate is generally much lower than the rate that a taxpayer will pay on his or her ordinary income.

Taxpayers in the highest tax bracket, for example, are subject to the highest ordinary income tax rate of 35%, but income from “qualified dividends” will only be taxed at a 15% rate. (There are several requirements that must be met before a dividend will be considered a “qualified dividend”, the most significant of which is that the investor must hold the stock for more than half of the 120 day period that begins 60 days before the ex-dividend date, and ends 59 days after that date.) Taxpayers who are in the 10% or 15% ordinary tax rate brackets currently pay no tax on qualified dividends. All taxpayers pay normal income tax rates on dividends that do not meet the tests for qualified dividends.

Prior to 2003, income from stock dividends was taxed the same as any other type of income – at the recipient’s normal income tax rate. In 2003, this tax rate was changed to the reduced levels we have today. But the 2003 reduction was only temporary measure, and it is currently set to expire at the end of 2010. If Congress does not act to extend the tax reductions for qualified dividends, then they will return to the standard income tax rates in 2011.

The current debate in Congress on this topic is highly charged, and the future of the dividend tax rate is unclear. But now is a good time to evaluate your current investment portfolio, and consider the changes you might want to make depending on whether the reduced rate on stock dividend income continues into the future.

For example, if Congress acts to extend the tax reduction, then you might wish to increase the weighting of dividend paying stocks in your portfolio. Rightly or wrongly, many investors are currently moving in this direction anyway, due to the low rates that are available for CDs and U.S. government bonds.

On the other hand, if Congress fails to extend the tax reduction, and the tax rate on dividends returns to pre-2003 levels, then individual investors need to evaluate how the increased tax affects their portfolios. Investors who own very few dividend-paying stocks (or mutual funds that hold the stocks of such companies) may see very little impact on their overall tax bill. But those who do hold a significant amount of dividend paying investments may want to evaluate whether it’s appropriate to continue owning such stocks, or perhaps whether it’s a good time to reduce your portfolio exposure (or at least to hold them in a tax-advantaged account like an IRA or 401k).

In any case, remember not to let your tax strategy lead you toward an investment decision that is not otherwise suitable for you or your circumstances.