Tax law changes affect dividends and capital gains

Q: How have these two laws affected the tax rates on dividends?

A: JGTRRA provided for lower tax rates on dividends that meet the definition of “qualified dividends.”

For taxpayers in income tax brackets higher than 15%, qualified dividends are taxed at 15% through December 31, 2008. For taxpayers in the 10% and 15% tax brackets, qualified dividends are taxed at 5% through December 31, 2007 and 0% in 2008.

TIPRA extended the 15% and 0% tax rates through December 31, 2010.

Because this provision “sunsets” December 31, 2010, tax rates will revert to 2002 rates in 2011 unless the rate cuts are extended or made permanent.

Q: What is a qualified dividend?

A: For a dividend to be a qualified dividend, three conditions must be satisfied:

1. The dividend must be received between January 1, 2003, and December 31, 2010.

2. The dividend must be paid:

   • by a U.S. corporation (including mutual funds)
   • by a corporation incorporated in a U.S. possession
   • by a foreign corporation located in a country that is eligible for benefits under a U.S. tax treaty that meets certain criteria
   • on a foreign corporation’s stock readily tradable on an established U.S. market (e.g., an American Depositary Receipt)
     
     

3. A specified holding period requirement must be met.

Q: Do mutual funds pay qualified dividends?

A: Yes, a mutual fund generally can pass on the qualified dividends it receives.

Q: How will shareholders know if they received qualified dividends from American Funds?

A: Shareholders will receive this information on their Form 1099-DIV, mailed in late January of every year.

Q: Do mutual fund shareholders have to meet a holding period requirement?

A: Yes. To be eligible to treat all or a portion of a fund’s dividend as qualified, a shareholder must have held the fund’s shares for more than 60 days during a 121-day period that begins 60 days before the fund’s ex-dividend date.

For example, Kate purchased shares of a mutual fund 60 days before its ex-dividend date. For a dividend to be qualified, she cannot sell her shares until the day after its ex-dividend date. Mark purchased shares of a mutual fund two days before its ex-dividend date. For the dividend to be qualified, he will have to hold his shares at least 59 days after the ex-dividend date.

Q: Are all dividends paid by a mutual fund qualified dividends?

A: No. A mutual fund may also pay income dividends that are not qualified, consisting of non-qualified corporate dividends (e.g., dividends received by the fund before January 2003 and dividends paid by certain foreign corporations), interest income and net short-term capital gains.

Q: What is the tax rate on dividends that are not qualified dividends?

A: Dividends that are not qualified dividends are taxed at the appropriate marginal tax rate for ordinary income.

Q: How is the foreign tax credit affected by qualified dividends?

A: Generally, the amount of the foreign tax credit a shareholder can claim is not affected by qualified dividends. However, for a shareholder who claims a foreign tax credit above $300 (single filer) or $600 (joint filer), the shareholder’s foreign tax credit may be limited. Shareholders should consult their tax adviser for more information.

Q: How do the lower tax rates on qualified dividends impact estimated taxes?

A: Every shareholder’s tax situation is unique. As a result, we strongly urge shareholders to consult their tax adviser to find out how the lower tax rates on qualified dividends may impact their estimated tax payments.

Q: Do the lower tax rates for dividends apply to retirement accounts and annuities?

A: Generally, withdrawals from retirement accounts and annuities are taxed at ordinary income tax rates. Thus, the lower rates on dividends do not apply to withdrawals from these accounts. Nevertheless, retirement accounts and annuities remain attractive investment vehicles, because earnings on these accounts can compound tax-free until withdrawn.

Q: How have these two laws affected the tax rates on capital gains?

A: Because of JGTRRA, the tax rates on long-term capital gains are generally lower.

The maximum tax rate on long-term capital gains (defined as gains on assets held for more than one year) was lowered from 20% to 15% through December 31, 2008. For taxpayers in the 10% and 15% tax brackets, long-term capital gains are taxed at 5% through December 31, 2007 and 0% in 2008.

TIPRA extended the 15% and 0% tax rates through December 31, 2010.

Because this provision “sunsets” December 31, 2010, tax rates will revert to 2002 rate in 2011 unless the rate cuts are extended or made permanent.

Q: What is the tax rate on capital gains that are not long-term?

A: Short-term capital gains (gains on assets held for one year or less) are subject to a taxpayer’s ordinary income rates.

Q: Are all long-term capital gains subject to the lower tax rates?

A: Only long-term capital gains from sales or exchanges made after May 5, 2003, and before December 31, 2010, are eligible for the lower tax rates.

Q: How has JGTRRA affected the lower capital gains rates on “qualified five-year gains?”

A: The tax rate depends upon the date of the sale or exchange.

• Sales or exchanges from January 1, 2003, through May 5, 2003, that resulted in qualified five-year gains may be eligible for the reduced 8% rate for taxpayers in the 10% and 15% tax brackets.

• For sales or exchanges from May 6, 2003, through December 31, 2010, the qualified five-year gain rule is repealed, and long-term capital gains are taxed at the lower 15% and 5% rates. In 2008, 2009 and 2010, for taxpayers in the 10% and 15% tax brackets, long-term capital gains are taxed at 0%.

• For sales or exchanges after December 31, 2010, the rates on long-term capital gains will return to the 20% and 10% levels. However, gains on sales or exchanges of assets held for more than five years will be eligible for the reduced tax rates of 18% or 8%, respectively, under the qualified five-year gain rules.

Q: How are mutual fund capital gain distributions taxed?

A: A mutual fund is able to pass on to its shareholders net long-term capital gains that qualify for the lower tax rates. Long-term capital gains realized by a fund prior to May 6, 2003, are not eligible for the lower tax rates.

Q: How do the lower tax rates on capital gains impact estimated taxes?

A: Every shareholder’s tax situation is unique. As a result, we strongly urge shareholders to consult their tax adviser to find out how the lower tax rates on capital gains may impact their estimated tax payments.

Q: Do the lower tax rates for capital gains apply to retirement accounts and annuities?

A: Generally, withdrawals from retirement accounts and annuities are taxed at ordinary income tax rates. Thus, the lower rates on capital gains do not apply to withdrawals from these accounts. Nevertheless, retirement accounts and annuities remain attractive investment vehicles, because earnings on these accounts can compound tax-free until withdrawn.

If you have questions about your specific tax situation, please consult your tax adviser.

Q: How did JGTRRA affect marginal tax rates?

A: Starting in 2003 and extending through 2010, marginal tax rates are lower than past years.

Because this provision “sunsets” December 31, 2010, tax rates will revert to 2002 rates in 2011 unless the rate cuts are extended or made permanent.