Dividend Tax Rates for 2013

Transcription

1 Dividends: Taxation and Investment Considerations February 2014 By Philip J. Harmelink and William M. VanDenburgh Philip J. Harmelink and William M. VanDenburgh discuss how the uncertainty regarding dividend taxation that was present at the end of 2012 is now replaced with a favorable and permanent preferential rate structure. The significant uncertainty regarding dividend taxation that was present at the end of is now replaced with a favorable and permanent preferential rate structure (as the Code is currently codified). High-income taxpayers face a higher preferential tax rate of 20 percent on dividends and long-term capital gains in conjunction with the new 3.8-percent Net Investment Income (NII) tax. This remains highly hl favorable compared to the newly reinstated ed top marginal al tax rate of 39.6 percent en on ordinary income. Additionally, ionally, taxpayers still receive the benefits efits from the lower graduated ated dividend tax rates sof zero ope percent ent and 15 percent. While the effective 23.8-percent top tax rate applicable to both dividends ds and long-term gains is materially higher than their prior preferential rate of 15 percent, it s significantly lower than the tax rates on other sources of investment income. Interest, shortterm capital gains, annuities, royalties, and passive rent income all face a top federal effective tax rate that is nearly double at 43.4 percent (the 39.6-percent regular rate plus the NII tax of 3.8 percent). Further, despite the Federal Reserve s plans to eventually taper off 2 on their highly accommodating interest rate stance, income-oriented investors still face a low interest-rate environment (ultra-low on the short-term obligations). Philip J. Harmelink, Ph.D., CPA, is the Ernst & Young Professor of Accounting at the University of New Orleans. William M. VanDenburgh, Ph.D., is the Robinson, Farmer, Cox Faculty Scholar Associate Professor of Accounting at James Madison University. Investors face difficult choices against a back-drop of low but likely rising interest rates and continuing volatility in equity markets as of the end of the third quarter of Importantly, the increased and different 2013 tax rate structures must be fully incorporated into taxpayers investment decisions. At the end of 2013, the 10-year Treasury note was yielding around three percent. While this has an appeal from a principal p assurance perspective (almost 100 percent), and to a degree from an income perspective, pect it comes with a high h federal tax cost. Federal marginal tax rates on interest can reach as high as 43.4 percent. In contrast, equity markets offer yields generally from two to three percent with a federal marginal tax rate that generally does not exceed 23.8 percent. Tax advisors must proactively convey to their clients the need to fully incorporate the new investment paradigm into their financial and tax planning Dividend Uncertainty At the end of the 2012, as the Code was codified, dividends were to be taxed as ordinary income with a tax rate of up to 39.6 percent in conjunction with the new 3.8-percent NII tax. The last time the ordinary income rate had been as high as 39.6 percent was in 1999 and dividends had been taxed at a preferential tax rate of 15 percent since Additionally, the maximum long-term capital gains tax rate was to become a maximum of rate of 20 percent plus the new 3.8-percent NII tax (this was in fact what occurred). TAXES THE TAX MAGAZINE 2014 P.J. Harmelink and W.M. VanDenburgh 55

2 Dividends: Taxation and Investment Considerations Not since 2002 has the long-term capital gain rate been as high as 20 percent. At the end of 2012, it was expected that an increase in the long-term capital gains rate would continue the advantage of long-term capital assets over most other asset classes (top federal effective rate of 23.8 percent versus 43.4 percent). Further, an increase in the dividend income tax rate was expected to increase the appeal of municipal bonds, which become advantageous to own when tax rates increase. Besides being exempted from the regular federal tax, municipal bond interest is not subject to the 3.8-percent NII tax. New Dividend Taxes and Rates for 2013 The new permanent preferential 20-percent tax rates on dividends and long-term capital gains, as the Code is written now, applies only after taxpayers taxable income exceeds $400,000 for singles, $450,000 for married filing jointly and qualifying widow/er, $425,000 for head of household and $225,000 for married filing separately. These income levels are where the 39.6-percent tax rate applies to ordinary income in 2013 (see Exhibit 1). 3 The threshold levels for the preferential eren tax rate on dividends and capital gains tax rates of zero percent, 15 percent and 20 percent are inflation indexed. The new NII Tax of 3.8 percent applies at different ent and much lower thresholds. When both investment ent income eand dmodified adjusted income exceed ed $200,000 for singles, $250,000 for married filing jointly, $250,000 for qualifying widow/er, $200,000 for head of household and $125,000 0 for married filing separately, the 3.8-percent tax applies. 4 Unlike ordinary income tax brackets that are inflation-indexed, the new NII tax brackets are not inflation-adjusted. A draft of the new Form 8960 for 2013, Net Investment Income Tax Individuals, Estates, and Trusts, is shown in Exhibit Tax Warning. As the net investment income tax income thresholds are not inflation-adjusted, more taxpayers will come under its grip each year (barring Congressional action). The draft Form 8960 and the IRS Question and Answers on the NII tax can help tax practitioners understand how this new tax will apply. The tax is applicable to individuals, estates and trusts. Individuals are subject to the tax if they have NII and modified adjusted gross income exceeding the income levels cited above. Estates and trusts are subject to the NII Tax if they have undistributed NII and also have AGI over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year. Draft Form 8960 has three parts consisting of: Part I: Investment Income (income such as interest, dividends, capital gains, rent and royalty income, nonqualified annuities, income from businesses involved in trading of financial instruments or commodities and income from businesses passive activities, etc.) Part II: Investment Expenses (amounts properly allocable to NII such as investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income and applicable state and local income taxes, etc.) Part III: Tax Computation (multiple-step process that taxes at 3.8 percent the smaller of net investment income or modified adjusted gross income minus threshold amounts that vary depending on filing status or if it is a trust or estate) More specifically, in Part I, taxpayers include taxable interest (line 1), ordinary dividends (line 2), annuities from nonqualified plans (line 3), income from rental real estate, royalties, partnerships, S corporations, trusts, etc. (line 4a) and an adjustment for net income or loss s derived in the ordinary course of a non Code Sec trade or business (line 4b). Line e5re requires es the inclusion of net tgain or loss from disposition of property. Part III, the computation, varies by whether the taxpayer is an individual or estate or trust. Estate and trusts must deduct distributions of net investment income and other deductions under Code Sec. 642(c) and reduce their adjusted gross income by the highest tax bracket for estates and trusts. Tax Warning. The reach of the NII tax is larger than it may first appear. For example, passive activities and the sale of a principal residence over the exclusion amounts are subject to it. Tax Tip. Because certain investment expenses are allowed to offset investment income for NII purposes, it s important that these expenses be carefully determined in full. In prior tax years, investment expenses were generally only allowed as itemized deductions that were disallowed for Alternative Minimum Tax (AMT) purposes.

3 February 2014 Thus, taxpayers often did not fully account for this tax item. Table 2. Corporate and Municipal Yields as of Sept. 27, 2013 Interest vs. Dividends Given the market gains of the past two years and the market crash of 2008 and 2009, many investors are skittish on whether or not to invest in equities. Fixed-income investors face the difficult choice of either earning very low interest rates or seeking investments that have higher stated income returns but with materially more risks. Table 1 shows current interest rates on Treasury obligations as of the end of September. Table 1. Treasury Yields as of Sept. 27, 2013 Treasury Yields at Constant Maturities Yield 3-month 0.02% 1 year 0.10% 3-year 0.66% 5-year 1.43% 10-year 2.66% 20-year 3.41% Interestingly, esting on September 6, 2013, the 10-year Treasury note approached a three-percent yield (it actually yielded do over three percent in Asian trading for the first time in over two years ). The 10-Year Treasury ry yield has steadily increased in 2013 as reflected ected din (at the ebeginning ning of 2013, it was under two percent). 5 At the end of September, as noted earlier, a 10-year Treasury note had fallen somewhat to around 2.6 percent (from its three-percent e-pe yield at the beginning of September). Higher interest rates are available if investors move out on the yield curve, or invest in corporate or municipal debt securities. These approaches have material risks. When interest rates almost inevitably rise, an investor with long maturities will miss out on higher rates until his/her securities mature and can be reinvested. Municipal investments, while tax-free on the federal level and potentially on state and local levels, come with often unrecognized default risks (the ongoing Detroit municipal bond default is one of the latest example). 6 Corporate bond issues can and have defaulted at times (for instance, General Motors). Table 2 reflects interest rates available on municipal and corporate obligations as of the end of Septembers On an after-tax basis, yields on municipal debt obligations were nearly double that of an Aaa Corporate bond. Pre-Tax Yield After Tax Yield (at 39.6% plus 3.8%) Corporate Aaa 4.54% 2.57% Bond Buyer Muni Index 4.53% 4.53% 20-Year General Obligation Tax Tip. While municipal debt obligations have higher principal risks, they are free of the regular federal tax as well as the new NII tax. Further, state and local specific municipal obligations can be completely tax-free. Tax Warning. Specified private activity municipal obligations, which often yield slightly more than regular municipal debt, are taxable for AMT purposes. Against a backdrop of low interest rates that are subject to the highest investor tax rates, investors are faced with equities markets that, while up nearly 18 percent as of the end of September 2013, were also subject to major and quick downward declines. As the WALL STREET JOURNAL reported at the end of August: The Dow Jones Industrial Average retreated eated 4.4% 4% to capped 1 ca p by a slide of points Friday for its largest monthly pullback this year after vaulting to a record high at the start of the month. Oil prices surged to a 2½-year high and the yield on benchmark U.S. Treasury notes continued to march toward 3%, registering 2.747%. 7 Besides capital appreciation (and sometimes depreciation), stock equity indexes in September 2013 were paying competitive dividends yields ranging from two percent to three percent (see Table 3). These dividends are generally subject to the preferential federal tax rate of 23.8 percent, which is significantly lower than 43.4 percent. Table 3. Dividend Yields as of End Sept Index Yield DJIA 2.20% Dow Utility 3.13% S&P 500 Index 2.08% TAXES THE TAX MAGAZINE 57

4 Dividends: Taxation and Investment Considerations Table 4. After-Tax Income of $100, Year T-Note vs. DJIA as of Sept. 6, 2013 (Rates Are Rounded) Broad Investment Choices Rate Pre-Tax Income New higher her tax rates and tax structures, s, in conjunction n with Federal Reserve monetary policies, combined to result in dividend-paying idend-pa ng stock still having gm multiple eadvantages ag over taxable debt obligations. However, er equity markets come with material risks of price volatility. A salient example is the approximate 50-percent decline in equity values seen in 2008 and 2009, which is still very much in the minds of most investors. From strictly an income perspective, an investment of $100,000 in a 10-year Treasury note or DJIA average dividend rate for a top bracket taxpayer is compared on a before and after-tax basis in Table 4 as of September 6, Granted, dividends are anything but assured, whereas U.S. Treasury interest is nearly assured (assuming Congress eventually lifts the debt ceiling or Treasury can prioritize debt and interest payments). Tax Tip. Investment in direct obligations of the U.S. Treasury or other direct U.S. obligations avoids state taxation on interest payments. Federal Tax 10-Year Treasury $100, % $3,000 ($1,302) at 43.4% DJIA Dividend Rate $100, % $2,500 ($595) at 23.8% Table 5. Vanguard 500 Index Investor Fund Dividend History (2002 to 2012) Date Dividend 2002 $ $ $ $ $ $ $ $ $ $ $2.70 State Tax ($150) at 6% After-Tax Income $0 $1,698 $1,755 of diversification. While companies do lower or even suspend dividend payments, one can mitigate these risks by investing through mutual funds. These funds often have hundreds of positions. Utilizing the Vanguard 500 Index Fund as a proxy, one can see that the dividend payment per share has fluctuated up and down from 2002 to 2012 but has over time generally increased as reflected in Table 5 (dividends paid by the Vanguard 500 Index Investor Fund were regular dividends that generally qualified for preferential rates if applicable). Based on Table 5, it would appear that an investment in a broad-based index fund would result in varying dividend payments but ones that over time increase (the dividend per share almost doubled from 2002 to 2012). Admittedly, history is no guarantee of future performance. Effective 50-Percent Tax Rates on Interest A high-income single taxpayer with $1,000 in taxable interest income and $400,000 in other income faces not only an effective federal marginal tax rate on the interest est income of 43.4 percent, but potentially state and local income taxation. Incorporating a state and local l tax of six percent, the effective tax rate becomes 49.4 percent. The impact of this combined effect on $1,000 in interest income is shown in Table 6. Table 6. After-Tax Income of $1,000 Interest Income (at Highest Marginal Tax Rates and 6% State Tax) Pre-Tax Income Federal Tax State Tax $1,000 ($434) at 43.4% ($60) At 6% After-Tax Income $506 Tax Warning. In 2013, $100,000 in pre-tax interest income can be subject to $49,400 in total federal and state income taxes for taxpayers in the reinstated 39.6-percent tax bracket, the new 3.8-percent NII tax, and a state tax rate of six percent. While dividend payments are purely discretionary, some protection can be obtained in the form 58 Tax Warning. In high tax rate states such as California, Hawaii, Oregon, Iowa, New Jersey,

5 February 2014 Vermont and New York, the effective rate could easily exceed 50 percent on an investor s taxable interest income. In fact, the top 2013 state income tax marginal rates of 15 states are higher than 6.6 percent, which added to the 43.4 percent make the total higher than 50 percent for federal and state top rates, California the highest at a total of 56.7 percent. See Exhibit 3 for states with individual income tax rates of 6.6 percent or more. Principal Assurance U.S. investors who seek absolute principal assurance have only two major U.S.-based choices, U.S. Treasury Securities (unlimited) or Federal Deposit Insurance Corporation (FDIC)- insured bank products (which are now limited). The unlimited insurance for non-interest bearing FDIC accounts expired December 31, The FDIC provides $250,000 total insurance to an individual for amounts in FDIC-insured institution. 9 FDIC insurance must be proactively assured and monitored. Not all banks are FDIC-insured. The FDIC guarantee applies only to certain bank products (checking and savings accounts, money market deposit accounts, and certificates of deposit). 10 Products that can be offered by a bank kb but not ti insured include mutual funds (stocks, bonds, and money markets), annuities and Treasury securities, 1 es, etc. 11 For the ultimate level of protection, on, investors should invest directly with the U.S. Treasury and not through h a financial al intermediary where e thirdparty risk is inherent (third-party custodian of assets concerns are eliminated). Investor Warning. Not all banks are FDIC-insured, so one needs to verify their bank is FDIC insured at Investor Tip. Direct investment in U.S. Treasury securities is available through Treasury Direct at Investor Tip. U.S. Treasury securities with maturities of as little as one day or as long as 30 years are auctioned through the U.S. Treasury. 12 Importantly, all other alternatives for cash holdings assume principal risks of varying magnitude. A salient example is that many investors, prior to 2008, incorrectly assumed Money Market Funds offered principal assurance. This is not and never was the case except for a temporary and now-ended U.S. Treasury emergency program in 2008 and As the Treasury stated on the expiration of its emergency program: As the risk of catastrophic failure of the financial system has receded, the need for some of the emergency programs put in place during the most acute phase of the crisis has receded as well, said (then) Treasury Secretary Tim Geithner. The Guarantee Program for Money Market Funds served its purpose of adding stability to the money market mutual fund industry during market disruptions last fall and ultimately delivered a healthy return to taxpayers. Treasury designed the Program to stabilize markets after a large money market fund s announcement that its net asset value had fallen below $1 per share ( broke the buck ) in the wake of the failure of Lehman Brothers in September of Maintaining confidence in the money market mutual fund industry was critical to protecting the integrity and stability of the global financial system. 13 This 2008 and 2009 financial crisis saw the Reserve Primary Fund break the buck as well as suspend redemptions. Ironically and sadly, this fund was actually run by Bruce Brent and his son, whom many considered the father or the inventor of the Money Market Fund. 14 The current SEC definition of a Money Market Fund states that these low-risk securities attempt to maintain a $1 net asset value (NAV), but this is not assured (see Exhibit 4 for the SEC definition of Money Market Fund). Besides direct losses, investors can face a seven-day redemption period or even longer periods in order to protect a money market fund s assets. 15 In June 2013, the SEC has proposed two rules that would change the structure of Money Market Funds 16 : 1. They would require floating NAV for prime institutional money market funds (thus the value would not be set at $1 per share) 2. They would allow all Money Funds to access liquidity fees and redemption gates in times of stress. Retail Money Market Funds would still have a stated $1 NAV. The Federal Reserve s 12 Regional Presidents criticized this SEC proposal as not going far enough. They argued that a floating $1 NAV should apply to all Money Markets and the restrictions on redemptions TAXES THE TAX MAGAZINE 59

6 Dividends: Taxation and Investment Considerations was not enough to reduce risks for a run on Money Markets. 17 In other words, principal assurance is anything but assured in money market funds despite the 2008 and 2009 financial crisis. Regulators are grappling with rule changes that would more clearly reflect this current reality. Conclusion Tax advisors and planners need to assure that their clients are factoring in radically new tax rates and tax structures into their investment planning. Highincome taxpayers can face an effective total tax rate of over 50 percent on their interest income and other forms of investment income in states with higher income tax rates. Utilizing a dividendpaying stock investment strategy has proven to be a highly valuable over the last decade despite the proclamation by some market pundits that they were mostly irrelevant in the technology boom and bust of the late 1990s and early 2000s. Despite a higher preferential tax rate of up to 23.8 percent, dividends still have a strong comparative advantage over the tax rate applicable to other sources of investment income (up to 43.4 percent on the federal level alone). Exhibit Ordinary Tax Rate Schedules

7 February 2014 Exhibit 2. Proposed Form TAXES THE TAX MAGAZINE 61

8 Dividends: Taxation and Investment Considerations Exhibit 3. States with Top Individual Income Tax Rates over 6.6%* State Rate California 13.30% Hawaii 11.00% Oregon 9.90% Iowa 8.98% New Jersey 8.97% Vermont 8.95% New York 8.82% Maine 7.95% Wisconsin 7.75% North Carolina 7.75% Idaho 7.40% South Carolina 7.00% Montana 6.90% Nebraska 6.84% Delaware 6.75% * taxfou rticle_ns/state in nc rates Exhibit 4. SEC Definition of a Money Market. 1 A money market fund is a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a money market deposit account at a bank, money market funds are not federally insured. Money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, or other highly liquid and low-risk securities. They attempt to keep their net asset value (NAV) at a constant $1.00 per share only the yield goes up and down. But a money market s per share NAV may fall below $1.00 if the investments perform poorly. While investor losses in money markets have been rare, they are possible. An investor tendering mutual fund shares, including shares of money market funds, for redemption generally must be paid within seven days of tender. Pursuant to Section 22(e) of the Investment Company Act of 1940, registered openend companies may not suspend the right of redemption and must pay redemption proceeds within seven days, except in certain emergencies or for such other periods as the Commission may by order permit for the protection of security holders of the company. Before investing in a money market fund, you should carefully read all of the fund s available information, including its prospectus, or profile if the fund has one, and its most recent shareholder report. Money market funds are regulated primarily under the Investment Company Act of 1940 and the rules adopted under that Act, particularly Rule 2a-7 under the Act. 1 sw 1 William M VanDenburgh, and Philip J. Harmelink, Dividends: Taxation and Investment Uncertainties, TAXES THE TAX MAGA- ZINE, Sept. 2012, at FOMCpresconf pdf html?mod=WSJ_Bonds_LeadStory. 6 ENDNOTES html html. 8 html work/auctime/auctime.htm SB html bruce-bent-sr-and-son-cleared-of-fraudcharges.html?pagewanted=all&_r= PressRelease/ #.UjTBprHn9aQ This article is reprinted with the publisher s permission from the TAXES THE TAX MAGAZINE, a month ly journal published by CCH, a part of Wolters Kluwer. Copying or dis tri bu tion without the pub lish er s per mis sion is prohibited. To subscribe to the TAXES THE TAX MAGAZINE or other CCH Journals please call or visit CCHGroup.com. All views expressed in the articles and col umns are those of the author and not necessarily those of CCH. 62