Federal tax rates on qualified corporate dividends were cut in 2003 from almost 40 percent to 15 percent. As a result, taxpayers in the 10 percent and 15 percent tax brackets currently pay no taxes on qualified dividend income. Congress extended this tax cut in 2006 and again in 2010. If it is not extended again by the Dec. 31 deadline, tax rates could rise to as high as 39.6 percent for those earning more than $250,000 a year.
Tax constancy Ernst & Young used Internal Revenue Service data to examine who will feel the biggest pinch from this increase. Analysts discovered that 25.4 million tax returns included qualified dividends in 2009, most of them from people at or near retirement age:
- Among taxpayers age 50 and older, 63 percent declared dividends.
- Among taxpayers age 65 and older, 32 percent declared dividends.
Of those declaring dividends, 68 percent had taxable incomes of less than $100,000 and 40 percent had incomes that were lower than $50,000.
We're not talking wealthy here.
Dividend-paying stocks have long been the retirement planning investment of choice for people who need steady income and who can't afford any risk. Utility stocks have been particularly popular because even today most pay somewhere in the neighborhood of 4 percent -- not great, but better than bonds.
It's inevitable that tax rates will rise. If we're going to continue to support the giant programs most of us want -- Social Security and Medicare -- we have to figure out how to pay for them. The perception is that increasing taxes on dividends will mostly affect high earners, who can afford it. But Richard McMahon, vice president of finance and energy supply for the Edison Electric Institute, says that's too simplistic.
He says raising taxes on dividends will not only affect small investors directly, it also could drive high-dollar investors elsewhere, which could push up the cost of capital and force utilities to sell more stock. That would lower dividend rates for small investors who don't have lots of other good investment choices. "Retirees can't invest in a dot-com stock and live off the growth because that won't pay the bills," McMahon says.
The Senate and the House are expected to take up this issue in August -- and Democrats and Republicans have polar opposite positions. But no matter how you look at it, holding down interest rates while raising taxes on dividends isn't retirement friendly.