Dividend tax cut brings its share of confusion

THE DIVIDEND tax cut was designed to be easy on the wallet, not on your accounting skills.

For fund investors who just received their tax paperwork, the confusion is only beginning.


A highly complicated detail of the new tax rules means that investors who sold funds might not get the full benefit of the dividend rate cut.

What's more, they may not know that they are making a mistake when they file.


The situation is the dark cloud that comes with the silver lining of the tax cut. What's more, investors -- and tax preparers -- are only just beginning to deal with it.

For now, the problem is best corrected by consumer knowledge. In the future, some common sense from Congress and the Internal Revenue Service could make things a whole lot better.

Here's the problem: The Jobs and Growth Tax Relief Reconciliation Act passed last year lowered the top tax rate on certain dividend income to 15 percent. Before the new rules, all dividend income had been taxed as "ordinary income" at rates up to nearly 40 percent.

The reduced rate applies only to "qualified dividend income," or QDI, in the jargon of tax pros. Only dividends from domestic corporations and foreign companies with a tax treaty with the United States qualify for this treatment.

But the issue is not just whether the investment qualifies, but whether the investor has done the right thing to earn the tax break, too.

Without getting too bogged down in specifics, investors don't qualify for the reduced tax rate if they don't own the issue for more than half of the 120 days around which the dividend was paid.

That's where the confusion really starts when it comes to the new tax rules and mutual funds.

The rules are much more complicated with stock ownership, margin accounts and more, but this discussion is limited to funds.


Say, for example, you invested in Fund X on Dec. 1, 2003, and the fund distributed dividends and capital gains on Dec. 9. Let's say your stake in the fund generated $500 in dividends, of which $250 were qualified.

The fund by now would have sent paperwork showing you that $250 qualifies for the lower rate.

But the fund company has no way of knowing if you qualify.

If you dumped the fund on Jan. 15 -- even though the sale occurred in a different tax year -- you weren't in it long enough to earn the better tax rate.

"The [Form] 1099 is just the starting point, it is not where you stop thinking and analyzing your transactions," says accountant Phil Holthouse of Holthouse, Carlin & Van Trigt in Santa Monica, Calif.

"It is similar to the wash sale rule that you run into with selling something and buying it back quickly. The firms sending you 1099s don't police the rules and they are counting on individuals knowing what to do. I don't think most people know what to do with this."


What makes this issue so tricky is that qualifying dividends are handled differently than most fund tax issues.

When a fund distributes capital gains, for example, it is the trading activity of the fund alone that determines how those gains are taxed.

So if you buy Fund X eight days before it distributes a long-term capital gain and dump the fund a month later, the fund's payout remains a long-term gain even though you held the fund such a short time.

"We should be able to say, 'If it's a qualified dividend to the fund, it's a qualified dividend to the shareholder,' " says Mark Luscombe, principal analyst at CCH Inc., which develops tax information for advisers. "That's what people would expect, but that's not the case."

Obviously, giving qualified dividends the same kind of treatment would solve the problem, but Congress and the IRS won't get that done this year.