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Some items that you might think of as interest are treated by the IRS as dividends, and vice versa. For example, distributions by money market mutual funds are considered "dividends," but ordinary distributions by tax-free municipal bond mutual funds are treated as "interest."
As of 1998, "ordinary dividends" you received from mutual funds reported in Box 1 of the 1099-DIV do not include the amount of any long-term capital gains distributions (i.e., net gains from sales of securities by the fund, which are passed through to the shareholders). Instead, your total long-term capital gain distributions are included in Box 2a, with more specific types of capital gain shown in Box 2b, 2c, and 2d. You then report these amounts directly on Schedule D, Capital Gains and Losses, Line 13, or to one of the worksheets indicated in the instructions to Schedule D. This allows you to more easily compute your tax at the special, lower long-term capital gains rate on Schedule D.
You must report and pay tax on the gross amount of all the ordinary dividends you were entitled to receive, even if you never actually received them because you reinvested them through a common-stock dividend reinvestment plan (DRIP) or a mutual fund reinvestment plan. If you paid any commissions or fees for reinvesting, you may be able to deduct them as investment expenses.
In 2003, Congress lowered the maximum dividend and capital gains tax rates for most (but not all) dividends and capital gains to 15 percent for qualifying taxpayers. Taxpayers in the 10- and 15-percent tax brackets are eligible for an even lower rate of five percent. In 2008, the rate for taxpayers in the 10- and 15-percent tax brackets falls to zero.
As originally enacted, these tax rate cuts were temporary and were scheduled to expire at the end of 2008. However, the Tax Increase Prevention and Reconciliation Act of 2005 extends the cuts for two more years through December 31, 2010.
Extending this tax break represents a significant tax cut for many of those affected. Once the extension ends in 2011, for example, those in the 35 percent income tax bracket will pay over 130 percent more tax on dividends!
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Save Money
If you do reinvest dividends, make sure that you keep track of them by saving the annual statements on which they are reported. If you keep good records, when you sell the investment, you'll be able to add the reinvested amounts to your basis in the investment, and pay less in capital gains tax. If you lose your records, in some cases the issuer of the stock or mutual fund will be able to tell you what your reinvestments were, but they might not be able to locate records that go back as far as you need.
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If you sold stock after a dividend was declared, but before it was paid, you are still treated as having received the dividend, and you must pay tax on it.
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