As part of the fiscal cliff, the top tax rate on dividends is scheduled to nearly triple in 2013. Here are some questions you might have:
What is a dividend? A dividend is a cash payment that a company makes to shareholders. Typically, it's expressed as a certain number of cents per share. This also allows you to express the dividend in terms of a "dividend yield." For example, a stock trading at $10.00 per share and issuing a dividend yearly of $0.25 per share has a dividend yield of 2.5% (that is, $0.25 divided by $10.00).
According to the latest IRS data, 25.4 million families receive "qualified" (stock-derived) dividends annually. In 2009, this totaled $124 billion. The total amount of dividends issued is far greater than this, since this only accounts for dividends flowing to individuals' taxable brokerage accounts. A February 2011 study by JP Morgan estimates that total dividend payouts look more like $700 billion.
What type of people receive dividends? Almost everyone benefits from dividends. If you are covered by a traditional pension or 401(k) plan at work, you almost certainly own dividend-paying stocks and mutual funds that own dividend-paying stocks. Ditto for your IRA or Roth IRA. Additionally, the IRS data cited above shows that over 25 million American families choose to receive dividends directly.
According to the Tax Foundation, the lion's share of dividends are earned in senior households (65 years and older). One-third of all households receiving dividends are senior households, and nearly half of dividend income is earned by seniors.
Aren't dividends just for wealthy people? Traditional pensions, 401(k)s, and IRAs are accounts for middle class Americans, not rich people. That's where many dividends end up. Additionally, nearly 23 million out of the 25 million American families that get paid dividends directly earn less than $200,000 per year. Over 40 percent of all taxable dividends are earned in these households.
How are dividends currently taxed? Dividends are not deductible to the company issuing them. Thus, they are drawn from after-tax corporate profits. When a dividend is received by an individual in a taxable brokerage account, he typically faces a tax rate of 15% federally–the same as the long-term capital gains tax rate.
How should dividends be taxed? Because dividends are derived from corporate income which has already been subject to tax, there should not be an additional tax assessed on the dividend recipient. To do so is to introduce a cascaded double tax. When put together with the 35 percent corporate income tax rate, the current integrated double-tax on dividends amounts to 44.75 percent federally. The proper tax rate on qualified dividends should be "zero."
How will the fiscal cliff increase taxes on dividends? There are two tax increases on dividends happening at the same time as part of the fiscal cliff. The first is that dividends will no longer be taxed at the same rate as long-term capital gains, but will revert back to their pre-2003 treatment and be taxed as ordinary income. In addition, Obamacare imposes a new 3.8 percent "surtax" on investment income for families making more than $250,000 beginning in 2013. When combined, these two tax increases result in a near-tripling of the top dividends tax rate from 15 percent today to 43.4 percent in 2013. The integrated top double-tax rate on dividends rises from 44.75 percent today to 63.21 percent in 2013:
|Dividend Only Rate||Double Tax Rate|
What will this tax increase do for shareholders? Efficient stock markets must price in changes to the tax rate on stocks. All things being equal, a higher dividend tax rate should result in a fall in company dividend yields, since dividends will be a less attractive return on investment. Historically, dividends represent about one-fifth of the total return on stocks. This suggests that the after-tax total return on stocks will become depressed as a result of a hike in the dividend tax rate.
What if I have all my savings in an IRA or 401(k)? I don't pay dividend taxes. Tax-advantaged accounts such as traditional pensions, 401(k)s, and IRAs don't face dividend taxation. They do, however, face the same corrective market forces described above. As a result, families' nest eggs should take a hit just like the broader stock market.
Congress should prevent the two tax increases on dividends from happening as part of the fiscal cliff.