In 2003, a tax cut law lowered the tax rate on qualified dividends to 15%. Before then, such dividends were taxed as ordinary income at rates as high as 35%. Given this new rate, some investors may have added more high dividend stocks to their taxable portfolios.
Qualified dividends in a taxable portfolio
Suppose that an investor has a taxable portfolio worth $100,000. Each year, this portfolio receives $5,000 in dividends, equal to a yield of 5%. With the 15% tax rate, the dividends incur an annual tax of $750. This investor also has a tax-deferred IRA portfolio worth $100,000. No stock in that portfolio pays a dividend.
If the 15% tax rate on dividends were to remain unchanged, the tax would total $7,500 over the next 10 years.
Dividends in a tax-deferred IRA
Suppose instead that the investor were to place the dividend paying stock in the IRA. The taxable portfolio, with no dividends, would have no tax. Within the IRA, $5,000 in dividends would accrue each year without tax. In effect, the investor would receive an interest-free loan on the deferred $750 tax. By reinvesting what would have been paid in tax, the IRA might also gain additional return.
After 10 years, the IRA would have received $50,000 in dividends. The bad news: a withdrawal at that time would be taxed as ordinary income, rather than at the 15% dividend rate. For those expecting a 25% marginal tax rate during retirement, the tax would come to $12,500.
At first glance, receiving dividends from the taxable account appears to save $5,000.
Choosing where to place high dividend stock is not so simple
For a better comparison, the deferred tax on the IRA withdrawal can be discounted to the present time. Using a 5% annual interest rate, the present value of a $12,500 tax, ten years from now, is $7,673. For the taxable portfolio, the present value of a $750 tax, each year for 10 years, is $5,791.
After considering the value of the tax deferral, placing the dividend stock in the taxable portfolio still saves about $2,000. Note that the investor's time horizon and tax rate during retirement would also affect the comparison.
A higher qualified dividend tax rate in 2011 spoils the party
For 2011 and beyond, ordinary dividends will again incur tax just like ordinary income. Investors receiving taxable dividends are in for a shock. First, the top marginal rate rises to 39.6%. Instead of $750, the tax on $5,000 of taxable dividends will rise to as high as $1,980 (at the 39.6% tax rate).
The choice becomes clear. Beginning in 2011, placement of dividend paying stock within an IRA account will offer a real benefit in lower taxes.