Q: Tax Playa, I have a bond mutual fund that pays me dividends. I'm paying ordinary income tax on them. I thought dividends were taxed at lower rates now.
Terrence, Arlington VA
A: Dividends vary in their taxation. As a general rule, corporate (qualified) dividends are taxed as capital gains, while all other dividends are taxed as ordinary income.
Dividends are cash payments made to investors for holding equity. They are much like interest. The difference is that interest is money paid to debt-holders, whereas dividends are money paid to share-holders.
Interest is fully-deductible to the payer (in the case of businesses). As a result, interest income is fully taxable to the recipient of interest. Tax rates go as high as 35%.
Some dividends that are paid have never gone through a prior level of taxation. Dividends from S-corporations, REITs, and bond mutual funds are good examples. Dividends from these securities are taxed liked interest, since there has been no prior layer of tax applied.
Most dividends, though, are issued from corporations to their shareholders. Dividends are not deductible against the corporate income tax. This creates a double-taxation problem on the personal tax level. Theoretically, dividends should either be deductible on the corporate level or face a 0% tax rate on the personal level. This would make all dividends equivalent to interest.
To mitigate the effects of the double taxation of dividends, Congress changed the law in 2003 to tax "qualified" dividends at the same rate as capital gains (currently taxed at a high of 15%). In order to be a "qualified" dividend, three tests must all be met:
- The dividend must have been paid by a U.S. corporation or qualified foreign corporation (defined as one that is in a U.S. possession, has a comprehensive income tax treaty, or is publicly traded on the major securities markets).
- The dividend is not from a capital gain distribution, tax-exempt lender, tax-exempt charity, ESOP plan, guaranteed payments, or payments in lieu of dividends. There must have been some prior level of taxation.
- The shareholder must have held the stock for 60 days during the 121 day period that begins 60 days before the ex-dividend date (the date the dividend is announced). Basically, active traders can't benefit.