The 2003 tax cuts reduced the tax rate on most ordinary dividends from the taxpayer's personal income tax rate to a maximum of 15%, equalizing the tax treatment of dividends and long-term capital gains. One result of the change was renewed focus on income investing. Many public companies initiated dividend programs to attract stable investors.
Unless the 2003 tax rates are extended, or new rules are enacted before then, dividends will be taxed at ordinary income rates once again after December 31, 2010.
The question for investors is how will that impact dividend payouts or the number of firms paying regular dividends.
Studies of corporate behavior following the 2003 tax cut show total dividends reversing their recent downward trend and special dividends spiking. Perhaps more important was the increase in the number of firms paying regular dividends.
With the expiration of the 2003 tax cuts, dividends again will be taxed at a taxpayer's personal tax rate. This could be as high as 43.5% when the tax to pay for health care, imposed on couples who earn more than $250,000 a year, goes into effect in 2013. In addition to giving the U.S. one of the highest dividend tax rates in the industrialized world, the change in dividend tax treatment can also be expected to change investor behavior and corporate dividend plans.
The reason is simple mathematics. A dividend of $10,000 will be worth $5,650 in after tax value at the highest income rates. A capital gain of $10,000 will have an after tax value of $8,000 based on the long-term capital gains tax rate of 20% effective 2011. The incentive to high income investors and corporations is to increase long-term capital gains and minimize dividends. Another advantage of long-term capital gains is that investors have greater ability to "schedule" the recognition of capital gains to offset losses.
For assets held in a tax-deferred retirement account, the tradeoff between dividend and long-term gain is a non-issue, because all withdrawals are taxed at the individual's personal income rate (with the exception of non-deductible IRA contributions where only gains are taxed).
What's the best approach for you to take with respect to dividends versus capital gains? The right answer depends on your personal circumstances.
Feel free to email me with any questions or comments at Paul@investfortomorrow.com.
Until next time…
Heritage Capital LLC