Beware! Not All Dividends Are Created Equal

Congress recently passed a bill reducing taxes on dividends from a maximum ordinary income rate of 35% to no more than 15%. This is great news for investors, especially those needing income from their portfolios. We believe the market has not fully recognized the benefit of this tax change, and high-dividend-paying stocks will continue to do well as people realize the comparative advantage of these investments. However, hidden in the fine print of the Jobs and Growth Tax Relief Reconciliation Act of 2003 were many exceptions to the lower rate. They complicated the rules in ways that will make investing and filing taxes even more confusing than before.

Here is a quick list of the major types of �dividends� that will not qualify for the new 15% tax rate and what you should do about them:

– �Payments in lieu of dividends� (PILs)
This is an exception that may really surprise investors, because few people know what PILs are. Basically, an investor may receive a PIL when they have a margin account and their broker lends stocks held in their account to another party. Since this other party now holds the stock, they get the actual dividend. The party that borrowed the stock gives the original investor a �payment in lieu of� that dividend to make up for the money rightfully earned. Since the PIL is taxed at a higher rate than the dividend, there is a problem. For 2003, the IRS has said it will not enforce the higher tax on PILs because brokerage houses were unprepared to report them correctly. However, in future years the IRS is likely to enforce it.

BWFA clients need not worry about PILs, because we have addressed this problem with TD Waterhouse, and Waterhouse has promised to reimburse any of our clients who owe additional taxes due to PILs. Investors who have margin accounts at other brokers should inquire whether they will be reimbursed for higher taxes. Not all brokers have made this promise.

– Dividends on stocks held less than 61 days
This one should not be an issue for BWFA clients because we never buy a stock with the intention of selling it in less than two months. However, it will increase the bookkeeping necessary for investors who want to ensure their dividends will qualify for the 15% rate.

– Dividends on money market funds and bond mutual funds 
The IRS considers these dividends interest income (not dividends) passed through from the bonds held inside these funds. Where possible, it would be preferable to hold such funds in retirement accounts.

– Dividends on preferred stocks
The new 15% tax rate is supposed to reduce the double taxation of dividends, first on the corporation�s tax return, then on the investor�s tax return. For some preferred stocks the corporation can deduct these dividends as an expense and not pay taxes on that income. Therefore, the new law does not give an investor a break on these dividends. Again, it is preferable to hold such securities in your retirement account.

– Dividends on Real Estate Investment Trusts (REITs)
Like dividends on preferred stocks, dividends on REITs have not been taxed at the corporate level and are subject to full tax rates at the individual level. Therefore, REITs are also best held in your retirement accounts.

– Dividends on foreign stocks that are not actively traded on U.S. stock markets
For most investors, this problem will occur on dividends paid by foreign stock mutual funds. Since such funds rarely pay much in dividends, it is not an important issue.