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By Jeremy Glaser | 05-28-2010 11:38 AM

Changes Coming to Dividend Taxation

Morningstar DividendInvestor editor Josh Peters thinks investors should guard against overreaction to proposals to change dividend tax rates.

Jeremy Glaser: The future of dividends and taxation. I'm Jeremy Glaser with Morningstar.com. I'm joined today by Josh Peters, editor of Morningstar Dividend Investor, to talk about what Congress and the administration is thinking about in terms of dividend tax rates in the future. Josh, thanks for talking with me today.

Josh Peters: Happy to be here. Wish it was a more happy subject. [laughs]

Glaser: [laughs] Well, as the Bush tax cuts are scheduled to expire, there could be some major changes to dividend tax rates. Could you talk a little bit about the history of dividend taxes?

Peters: Yeah, I think it's important to remember that dividend investing, and the appeal of dividend investing - getting that steady stream of cash that's coming directly out of the profits of the companies, that you own a share of, are earning - that's been around a long time. Even when tax rates were 93 percent in this country, companies still were paying dividends, because that is essentially what companies are paid to do, or are organized to do, on behalf of their investors.

And you go back all the way to the creation of the federal income tax, dividends were typically taxed as ordinary income, which in some cases would be very high top marginal rates for the highest earners, while capital gains were taxed at lower rates. Then, 2003, finally we had dividends and capital gains, which really both come from the same ultimate source, which is corporate profitability, put on an equal footing with a maximum tax rate of 15 percent.

That's been the status quo since 2003, but these tax cuts, like a lot of other tax cuts in that piece of legislation, will automatically expire at the end of 2010. If Congress does nothing, if there is no change to the actual tax code, then next year long-term capital gains taxes would rise to potentially a top bracket of 19.8 percent, while the taxes on dividend income could go as high as 39.6 percent. That was the old top marginal tax rate before the '03 Act.

Glaser: What are some of the proposals out there now for changing the legislation or changing the tax code?

Peters: I kind of look at there being two main options, although it's even kind of hard to characterize them as proposals or specific legislation. I mean, it's very murky, and this issue has really been on the back burner of a lot of people's thinking in Washington. There's so many other more pressing problems that would seem that the government has to attend to.

But the first is, what the president has proposed, and in fact proposed it back in his campaign days, which was to create another 20 percent tax bracket - that would apply to both qualified dividends and long-term capital gains - for higher earning households, married, filing jointly, above $250,000 a year. That would be a tax increase. I'm not going to characterize it as pleasant. But it is a more moderate approach, as opposed to going back to the old tax rates.

The only piece of legislation, that has actually started to move in Congress, which is the senate budget for next year, has actually proposed to keep the existing tax rates capped at 15 percent for households under that $250,000 mark. But, after that point, the old tax rates, the top 39.6 percent, would come back. And even worse I think, than the tax rates being increased on both dividend income and long-term capital gains, is that you'd go back to that penalty rate essentially on dividend income.

That long-term capital gains are somehow being deemed as better indirectly by the government, while dividends are paid, pay taxes at a much higher rate. I think that has a lot of drawbacks, and that companies perhaps don't think real clearly about capital allocation when they start looking at the way the taxes line up.

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