Thursday, May 08, 2003

Tax Dividend Bait-and-Switch. The Senate is supposed to have agreed on a tax package that will make the first $500 of dividend income tax exempt and exempt 10% of all dividends above $500. The problem with the tax cut is that it doesn't significantly encourage larger investors to buy dividend-paying stocks; a 10% exemption will add a very small amount to the marginal return on stocks. On page 17 of this report on 2000 tax returns, the average person who reports dividends gets about $4,300 based on 34 million people getting dividends and $147 billion in reported dividend income. Note that this is the mean and not the median; I'd like to see the stats that Charles Grassley is citing here that that covers 86 percent of taxpayers with dividend income. This will only marginally affect the marginal after-tax return of investors with large dividends, adding about 0.12% to after-tax returns on dividend-paying stocks, assuming a 4% yield and a 30% marginal rate. That's not going to make a big dent in people choosing stocks income over bond income. The first winner here would seem to be credit unions; their basic savings accounts are shares in the credit union and payouts are officially called dividends. That would make them tax exempt. The second winner here would be stock income mutual funds. Small investors could have about $10,000 worth of funds in stocks earning tax-free dividend income. The third winner would be discount brokers. One trick that has been used in the past is called dividend-capture, where you buy a stock just before it's due to pay out the dividend, then once the stock goes ex-dividend, you sell the stock. You've have a dividend and a capital loss roughly equal to the dividend. If you have $50,000 you could play with for a few days, you could buy 1000 shares Jefferson Jointroints stock at $50/share just before it was about to pay a $0.50/share dividend. On the ex-dividend date, you then sell the stock for $49.50, since the stock's value has lost weight after giving birth to a dividend. You now have a $500 dividend and a $500 capital loss (plus any brokerage fees). If you're in the 28% bracket, you've just got a nearly risk-free $140 tax break for your trouble. However, you can only do this once a year for the full effect. For those people in the big-money class, they'd only get a $50 net tax loss, barely worth the effort; they're limited to $3,000 of excess capital losses each year, so that trick wouldn't work too well.

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