Qualified Dividend

In her taxable account this year Rosamund Ferreira receives three dividends: (1) from a U.S. common stock she has owned for four years; (2) from a U.S. common stock she bought 20 days before the ex-dividend date and sold 12 days after it; and (3) an ordinary dividend from an equity REIT. Which of these are QUALIFIED dividends taxed at long-term capital gains rates?

1. A.(1) and (2), because both are dividends on U.S. common stockA U.S. issuer is necessary but not sufficient. The 32-day holding in (2) fails the more-than-60-day requirement.
2. B.All three, because all three are dividends paid by U.S. issuersBoth the holding period test and the character of REIT ordinary dividends defeat this.
3. C.(1) and (3), because REIT dividends are always qualifiedREIT ordinary dividends are generally NOT qualified, precisely because REIT income is not taxed at the entity level.
4. D.Only (1)Correct. The four-year holding qualifies; the 32-day trade fails the holding period test; REIT ordinary dividends are generally not qualified.

Why: To be a qualified dividend the payer must be a U.S. or qualifying foreign corporation and the shareholder must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. The four-year holding in (1) clears that test comfortably. In (2) she held the shares only 32 days in total, so the dividend is taxed as ordinary income. REIT ordinary dividends in (3) are generally not qualified, because the REIT itself deducts what it distributes and pays no corporate-level tax on it.

A participating whole life policy issued by a mutual insurer pays an annual policy dividend. Which statement about that dividend is correct?

1. A.It is a guaranteed contract element that must be paid in each year the policy stays in force.Wrong. Dividends depend on actual mortality, expense and investment experience and are illustrated rather than promised.
2. B.It is taxable at the preferential rates that apply to qualified corporate distributions on stock.Wrong. No stock is involved and no corporate earnings are being distributed, so those rates have nothing to attach to.
3. C.It represents the share the policy holds in the separate account investment return for that year.Wrong. A whole life policy has no separate account, because the general account carries the contract entirely.
4. D.It is treated as a return of premium and is generally untaxed until dividends exceed the owner cost basis.Correct. Refunding an overcharge reduces what the owner has net invested, so tax waits until basis is used up.

Why: A policy dividend is the way a mutual insurer returns the margin between what it charged and what its mortality, expense and investment experience actually cost. Because it is a refund of an overcharge rather than a distribution of profit on invested capital, it is treated as a return of premium and is not taxable until cumulative dividends exceed what the owner has paid into the contract. It is also an illustrated figure, never a guaranteed element, and an insurer may reduce or omit it. If the owner leaves dividends on deposit to earn interest, that interest is currently taxable even though the dividend itself is not.

Qualified cash dividends received by an individual investor are generally taxed at...

1. A.Long-term capital gains ratesCorrect — qualified dividends are taxed at the favorable long-term capital gains rates.
2. B.A flat 50 percent rateNo such flat dividend rate exists.
3. C.They are always tax-freeQualified dividends are taxed, just at lower rates.
4. D.Ordinary income rates in every caseOnly nonqualified dividends are taxed as ordinary income.

Why: Qualified dividends are taxed at the lower long-term capital gains rates rather than at ordinary income rates, provided holding-period requirements are met.

A client compares holding a growth stock portfolio in a taxable account with holding the same portfolio inside a nonqualified variable annuity. Which statement about the annuity is correct?

1. A.Gains are deferred but emerge as ordinary income, and the contract receives no basis step-up at death.Correct. It names both costs of the wrapper, the rate conversion and the loss of the step-up.
2. B.Gains are deferred and emerge as long-term capital gain where the contract was held over a year.Wrong. Holding period governs assets sold in a taxable account and does nothing for distributions from a contract.
3. C.Gains are deferred and the beneficiary receives a step-up that eliminates the deferred gain.Wrong. A nonqualified annuity is income in respect of a decedent and is expressly denied that adjustment.
4. D.Gains are taxed each year but at the rate applying to qualified dividend income.Wrong. Annual taxation is exactly what the annuity wrapper prevents, so this describes the taxable account instead.

Why: The annuity wrapper defers tax while the portfolio grows, but it also converts what would have been long-term capital gain and qualified dividend income into ordinary income on the way out. It further gives up the basis step-up at death, because a nonqualified annuity is income in respect of a decedent and the untaxed gain passes to the beneficiary intact. Deferral is therefore purchased with the loss of two preferential tax outcomes, plus the contract-level charges. The trade favours the annuity only where the deferral period is long and the ordinary rate of the owner at distribution is low enough to offset the rate conversion.