Dividend Tax Rates: What Investors Need To Know

By James E. McWhinney AAA

Prior to 2003, the number of companies paying dividends to their shareholders had been on the decline for a quarter of a century, according to the American Shareholders Association. That trend reversed dramatically with the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) on May 23, 2003. Among a host of other tax law changes designed to jump-start the economy, this piece of legislation temporarily reduced the top individual income tax rate on corporate dividends to 15%. It also reduced the top individual income tax rate on long-term capital gains to 15%. However, the JGTRRA has a sunset provision, and it expired on January 1, 2011. Here we look at the implications of this legislation, the history that led up to it, and the effect this change in tax law had on investors and corporations.

Tutorial: Stock Basics

Tax Laws Changes Stemming From JGTRRA
The passage of the JGTRRA led to immediate - and ongoing - changes. By year-end 2003, more than 242 companies had increased the amount of their dividend payments. Payments increased again in 2004 and 2005, 2006 and 2007, according to data provided by Standard & Poor's, until the party finally ended in 2008 and 2009 as a result of the mortgage meltdown and credit crisis. (For background reading, see How And Why Do Companies Pay Dividends? and How Dividends Work For Investors.)

Stipulations in the Legislation
The rate change implemented by the JGTRRA applied to dividends from domestic corporations and "qualifying foreign corporations", which includes any foreign company trading on an established U.S. securities exchange, incorporated in a U.S. possession, or incorporated in a country where certain treaties with the U.S. are in effect. The rate change does not apply to dividends paid by the following:

  • Credit unions, mutual insurance companies, mutual savings banks, farmers' cooperatives or tax-exempt cemetery companies
  • Any corporation that is exempt from federal income tax
  • Securities owned by an employee stock ownership plan
  • Stocks owned for fewer than 60 days during the 120 days before and after the stock's announced ex-dividend date (usually two days prior to the dividend payment date) - a condition designed to stop investors from buying a security, holding it until the dividend is paid and then selling it
  • Real estate investment trusts (REITs)
  • Investments, such as short sales, that require a related payment in substantially similar or related property

History of Dividend Taxation
To fully understand the impact of the JGTRRA, we need a brief overview of the state of taxation prior to its passage. Taxation began with an initial corporate income tax, generally at a rate of 35%, which was levied against each dollar of profit that a corporation earned. Once that tax was paid, the remaining money was used to pay dividends to investors. At that point, the dividend payment was classified as income (for the investors) and taxed again. For taxpayers in the highest tax bracket, income tax took 38.6% away from each dollar of profit that they received from dividend payments.

Corporate CEOs have long been plagued by this double taxation. Keep in mind that corporations exist to serve their shareholders. When corporations generate profits, there are only a limited number of ways for those profits to be put to work or distributed to investors. Citing dividend payments as an inefficient use of capital, corporations historically preferred to invest in activities that generate capital gains, on which investors also paid tax, albeit at the significantly reduced rate of 20%. This encouraged companies to spend their earnings on research and development, new equipment, stock buyback plans and other efforts to build and strengthen their businesses. Ideally, these efforts would boost the firm's stock price and ultimately result in a larger return on investment when investors sold their shares. (To learn more, see What is the double taxation of dividends?)

The JGTRRA dramatically changed the situation. The reduction of the tax on dividends was one major development. The reduction in the tax on long-term capital gains from 20% to 15% for taxpayers in the highest tax brackets was another. This equalization served to help level the playing field between the various methods of profit distribution available to publicly-traded corporations.

Good for Investors
Relying on steady dividend payments from industry stalwarts such as General Electric, Johnson & Johnson and Coca-Cola (to name just a few) is not a new strategy for income-seeking investors. Because Wall Street analysts view steady dividend payments as a sign of strength and cutting dividends as a sign of weakness, firms with a strong history of dividend payments tend to maintain those payments over time. The reliable income stream provided by these established, slower-growing blue chip firms earned them the nickname "widow and orphan" stocks, because they provide a high degree of safety for risk averse investors. (To learn more, see "Widow And Orphan Stocks": Do They Still Exist? )

With the passage of the JGTRRA, dividend-paying stocks have become even more attractive, particularly for investors in the highest tax brackets. While the income produced by bonds and other fixed-income investments is taxed as ordinary income at rates of up to 28% for taxpayers in the highest bracket (tax bracket reduction was another benefit of the JGTRRA), the 15% tax rate on dividend payments is a bargain. Investors in lower tax brackets also benefit from lower tax rates on dividends, with the tax on dividends dropping to 5% for investors in the 10% or 15% income tax brackets.

While lower taxes are an immediate and direct benefit, they aren't the only benefit investors receive from the JGTRRA. Consider the impact on stock prices when a firm announces a new dividend payment or increases the amount of an existing dividend payment. When such announcements are made, the firm's stock generally becomes more attractive to investors and, as a result, the firm's stock price tends to increase. This increase results in greater capital gains for investors when the shares are sold.

The financial benefits of dividend payments aside, there is also a less tangible, but considerable, psychological benefit. While it can't be measured in dollars and cents, the increase in the number of companies paying dividends serves to soothe investors' nerves in a time plagued by corporate scandals - the generation of paper profits via Enron-style shenanigans is much harder to perpetuate when large amounts of cash are required to meet dividend payment obligations.

Good for Corporations
From a corporate perspective, dividends are part of a company's cost of capital. Reducing the tax on dividends made it less expensive for companies to do business by making it cheaper for them to return money to investors. It also encouraged them to invest corporate earnings more efficiently, seeking the most profitable business opportunities as opposed to seeking any opportunity that enabled them to avoid making a dividend payment.

Make no mistake, corporate executives received substantial benefits too, since they generally rank among the largest shareholders in the firms that they run. You won't hear them boasting about it, but dozens of major corporations made massive dividend payments that resulted in a virtual goldmine for senior executives. These executives received millions of dollars worth of dividend payments that were taxed at 15%, as opposed to the 28% tax rate that would have applied to ordinary income.

Conclusion: A Limited Time Offer?
Although JGTRRA expired at the end of 2010, Congress has extended the cuts made under this law until 2012. But as with any limited offer, even if it is too early to tell which way the political winds will blow, savvy investors should be careful not to put themselves in a position where they are relying on an income stream that could be dramatically reduced. However, it seems likely at this point that the majority of the provisions of this act will be carried forward for most taxpayers.

To read more on this subject, see Dividend Facts You May Not Know.

comments powered by Disqus
Related Articles
  1. Digging Into The Dividend Discount Model
    Markets

    Digging Into The Dividend Discount Model

  2. Some Good News Is Bad News For Investors
    Markets

    Some Good News Is Bad News For Investors

  3. The Power Of Dividend Growth
    Investing Basics

    The Power Of Dividend Growth

  4. Dissecting Declarations, Ex-Dividends ...
    Investing Basics

    Dissecting Declarations, Ex-Dividends ...

  5. The Perks Of Dividend Reinvestment Plans
    Fundamental Analysis

    The Perks Of Dividend Reinvestment Plans

Trading Center