Are Dividends Really as Taxing as Firms Claim?

Eliminating the double taxation of dividends has become a rallying cry of many investors, politicians and pundits who think it's the surest route to everything from economic recovery to market reform.

Like all catchphrases, though, the term is slightly misleading and shrouds a much larger, complex issue.

The term comes from the fact that corporate profitability, when distributed as dividends, is taxed once at the corporate level and again at the individual level. Public companies generally pay a 35% tax on their profits. If they opt to distribute some of the remaining profit in the form of dividends, the individual receiving the dividend also pays ordinary income tax on the distribution -- that can be as much as 38.6%.

Let's say a company has a profit of $10 a share it decides to distribute as a dividend. That $10 is taxed at 35%, which means the company now has $6.50 per share to distribute. The individual who receives that $6.50 pays ordinary income tax on it -- if the investor is in the highest tax bracket of 38.6%, that's $2.50 in tax. Now the net dividend the individual receives is $4. That's a net of $4 on $10 of corporate profit.

Breakdown of Taxes on Dividends

(And yes, you'll still owe that tax if you reinvest the dividends. The reinvested dividends, though, will increase your cost basis in the shares, which will eventually mean you'll pay less in capital gains tax when you sell the stock.)

Talk of eliminating the double taxation of dividends has been bouncing around Congress and Wall Street for a number of years. There are currently at least two bills in the House that propose "fixing" this issue, and the new Republican Congress that begins in January will likely include the issue along with a slew of other tax-policy changes, according to Chris Edwards, director of fiscal policy studies at the right-leaning Cato Institute.

Spare Change

Clearly, wealthy investors (those in high tax brackets and with a big investments in dividend-paying stocks) are hit the hardest most immediately. Even so, about half the dividends distributed escape immediate taxation, according to William Gale, a senior fellow at the Brookings Institution.