As investors may already be discovering, there's a downside to the new 15% maximum rate on dividends. Accounting for these payouts at tax time has become a lot more complicated -- not just this year, but going forward as well.
The problems are twofold. First, the 15% tax rate applies only to dividends deemed "qualified." The 1099-DIV forms that investors receive ahead of tax season now list "qualified dividends" -- those that get the special tax treatment -- in addition to total or "ordinary" dividends. Brokers and fund companies are required to determine which ones are qualified and which ones aren't, but the industry has warned that mistakes will be made this year as it adjusts to the new rules. Even if you have qualified dividends, you won't get the 15% rate unless you adhere to complicated holding period requirements. It's up to you to keep track, and the stakes are high, since those who fall short may end up paying tax at ordinary income rates of up to 35%.
Typically, distributions from preferred stocks and real estate investment trusts aren't qualified. Still, about one-third of REIT dividends qualified for the 15% rate in 2003. Foreign stocks listed on U.S. exchanges or from most countries with tax treaties with the U.S. can get the 15% break, too. For tax info on preferred stock, check QuantumOnline.com. Be aware that dividends from bond and money-market funds are really interest and don't get the special tax treatment.
DO THE MATH
The new holding period rules are tricky. To claim the 15% rate, you've got to own a stock for at least 61 days, says Don Weigandt, a wealth adviser at JPMorgan Private Bank. But here's the catch: This has to occur within a 121-day window that begins 60 days before the "ex-dividend date." (That's when a stock buyer isn't eligible to receive the recently declared dividend.) For a stock with a Mar. 1 ex-dividend date, for example, you've got to hold for 61 days between Jan. 1 and Apr. 30. DivTracker, a Web tool that charges $19 for a six-month subscription, can do the calendar math for you. Since the same rule applies to mutual funds, many fund firms are alerting clients to the new holding requirements. Vanguard Group has also sent statements to those with potential holding period problems and has a free online calculator for its own funds.
The 15% rate is off-limits in other situations as well. If you've hedged a stock for more than 60 days during the 121-day window, you're out of luck. Moreover, if your stock pays a dividend while your broker has it on loan to a short-seller, you may be able to claim the 15% rate -- but only on your 2003 return. In the future, you'll be hit with ordinary income tax on these payments. That's because in such arrangements, the income you receive isn't really a dividend. Instead, it's a payment "in lieu of a dividend" that compensates you for the dividend you lose out on while the stock is on loan, says Martin Nissenbaum, a partner at Ernst & Young. Make sure your broker has a plan to reimburse clients for the extra tax they'll pay in this situation. With tax rates on dividends so low, you shouldn't lose an opportunity to take advantage of them. By Anne Tergesen