Tuesday January 13, 2004

What Your Broker Isn't Telling You About Dividends

The last tax act that passed congress made many dividends taxable at only a 15% rate (sometimes less), this is significant because they are usually taxed as ordinary income (when held outside retirement plans - dividends inside retirement plans are tax-deferred and tax as ordinary income when distributed). This is a significant development in the world of stocks and has some people changing their portfolios. What most people don't know is that their dividends may actually be taxable as ordinary income, not at the 15% rate - the reason? Their brokerage firm.

In the new tax act their is a provision that makes dividends taxable as ordinary income if received from the lending of your securities. Without getting into the specifics, brokerage firms make big money lending your stocks to other institutions (such as hedge funds), however when they do this the institution that borrows the stock receives the dividend and you receive an "in-lieu" payment of equal amount, the problem is that this "in lieu" payment is taxable as ordinary income because it isn't really a dividend. There is a simple solution to this problem, don't open a margin account - if your taxable assets are held in a straight "Cash" account without Margin than your brokerage firm cannot lend your securities out.

Don't count on your brokerage firm to tell you this though. As I stated earlier, they make big money lending your securities out to others and face a conflict of interest by telling you to switch to a cash account. They lose out on potential gains by telling you to switch, yet it is usually in your best interest. This is yet one more example of how brokerage firms take advantage of their clients and do not put their interests first. If you think this is limited to just the major brokerage firms that I usually rag on (Merrill, Morgan, Smith Barney - etc) you are wrong. Fidelity is in on it as well - the disclosure they send to their clients reads: “You are not entitled to any compensation in connection with securities lent from your account or for additional taxes you may be re-quired to pay as a result of any tax treatment differential between substitute payments and actual interest,” - of course you first have to find this disclosure...Goodod luck.

If Fidelity and the other institutions were truly putting your interests first they would do more - they would write letters in plain english and urge you to switch your account to a cash account and even include the forms. Better yet they would automatically switch you if you didn't sign an opt-out form. This is just one more reason you need someone looking out for you - you can't count on the regulators and you can't count on your brokerage firm.

If you want more info on this subject just e-mail me and I will send you a link to a good article.

Until Next Time............