Taxation of Dividends

A friend recently told me that the capital gains rate is actually lower than the the tax rate for ordinary income. This is true. I goofed on the explanation in my first blog post, but the tax benefit of dividends remains. Here is the correction:

Most people in middle tax brackets or higher want their dividends taxed at the capital gains rate, which is 15%, not the ordinary income rate, which varies but is roughly in the 24-28% area for middle to upper brackets.

However, almost all dividends paid to holders of individual stocks are "qualified dividends."

What is a qualified dividend? It is simply a dividend that "qualifies" for taxation at the lower capital gains rate. There are three criteria for this treatment:

1. The dividend must have been paid by an American company or a qualifying foreign company.
2. The dividends are not listed with the IRS as dividends that do not qualify.
3. The required dividend holding period has been met.

Although most dividends paid on individual stocks are "qualified," be careful about ETFs and mutual funds, because these are more likely to issue "ordinary dividends." Recently more funds are being marketed as "tax efficient" and these are more likely to issue qualified dividends.

The tax law providing this favorable treatment was going to be sunsetted (is that a word?) at the end of 2008, but Congress recently extended it to 2010, so (for now) the tax break is safe.

Congress ought to make this treatment permanent and provide the nation's taxpayers a real incentive to save. The savings rate in the USA is abysmal, and punitive tax law is in part to blame.