Education: Growth & Income Investing

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The Tax Cut on Dividends

"Double taxation is bad for our economy. Double taxation is wrong.”

These words were uttered by President George W. Bush in 2003 when he proposed to eliminate the U.S. dividend tax. He went on to state, "It's fair to tax a company's profits, it's not fair to double-tax by taxing the shareholder on the same profits." Makes complete sense to me. However, some did not completely see eye to eye with the President. Let’s dig a little deeper.

The Jobs and Growth Tax Relief Reconciliation Act of 2003

The Congress of the United States of America eventually passed a bill that included several of the tax cuts requested by President Bush, who quickly signed the bill into law on May 28, 2003. The legislation was entitled The Jobs and Growth Tax Relief Reconciliation Act of 2003 (commonly referred to simply as the JGTRRA).

In a nutshell, the JGTRRA lowered the tax rate for qualified dividends to 15% for most individual taxpayers and to 5% for taxpayers whose income places them in either the 10% or 15% tax bracket. This 5% will last through Dec 31, 2007 and drop to 0% in 2008. Prior to the signing of the bill, dividends were taxed at the same rate as ordinary income. These tax benefits were scheduled to expire on Jan 1, 2009; however, Bush signed a two-year extension of the reduced 15% tax rate for capital gains and dividends into law on May 17, 2006.

A qualified dividend is generally defined as a dividend paid on common stock and certain preferred stock, subject to holding period and hedging requirements. Investors must have held the stock for at least 60 days out of the 120-day period beginning 60 days prior to the ex-dividend date. For more information on the ex-dividend date, please read our article “Understanding Dividend Dates.” Please keep in mind that the holding period also applies to dividends received from shares of mutual funds. Most income from foreign companies, real estate investment trusts (REITs) and bond coupons are not considered qualified dividends.

Proponents of the Dividend Tax Cut

The most common argument made for the reduction of the dividend tax pertained to what is commonly referred to as double taxation. When a company is fortunate enough to turn a profit, it is forced to pay income taxes on its earnings. For those companies that decide to distribute a portion of its profits in the form of a dividend to its shareholders, these individuals are also required to pay Uncle Sam. Many do not believe this double taxation is entirely fair, thus, a compromise was reached leading to the JGTRRA.

Advocates also claimed that the new tax law would encourage Americans to purchase more stocks, pushing share prices up as a result. The market, as represented by the S&P 500, has done particularly well since the bill was signed into law, posting returns of 28.7%, 10.9% and 4.9% from 2003 to 2005, respectively. Higher stock prices should then, in turn, lead to consumers spending more. The same can be said for lower taxes—more money in investors’ pockets and hopefully more money pumped into the U.S. economy as a result.

Supporters also pointed to companies contemplating between paying a dividend versus reinvesting their excess cash. The new way that dividends are treated will encourage these companies to possibly lean towards the dividend side of their conundrum.

Opponents to the Dividend Tax Cut

Many argued that dividend income is a very small percentage when compared to total income. Furthermore, a great deal of dividend income goes into 401(k) plans, Individual Retirement Accounts (IRAs) or other tax-deferred investment vehicles. As a result, those participating in these plans, which allow taxes to be deferred until they are withdrawn at retirement, will not even benefit from the new tax law.

Critics also stated that wealthy Americans are the ones most commonly receiving dividend income. Will a fattening of their pockets really cause them to spend more than they normally would have? Probably not—they were already well off before this newfound wealth.

Show Me the Money

While the dividend tax cut has gotten mixed reviews, one thing can be said for sure, the legislation has led to more money in the pockets of growth and income investors. Whenever individual income taxes can be reduced, I am all for it, aren’t you?

When the extension was officially signed into law, the GOP stated that the tax cuts, first enacted in 2003, created 5.2 million jobs since August 2003. Furthermore, they helped spur growth by keeping $880 billion in taxpayers' pockets during the past five years. Growth and income investors, keep your fingers crossed for a permanent extension one day.