When is a dividend not a dividend?

When a “dividend” paid by a mutual fund doesn’t qualify for the dividend tax cut just approved by Congress.

All types of mutual funds, including cash-like money market funds, pay what are called “dividends” to investors. But not all of those dividends are what Congress had in mind when it decided to slash the top rate on stock dividends to 15% from the current 38.6%.

Income paid out to shareholders by mutual funds, like other corporate entities, is technically a dividend, explains Joel Dickson, a principal and tax specialist at Vanguard Group in Malvern, Pa. But even so, the income passed along by a mutual fund retains its original character for tax purposes.

So in the case of a bond fund dividend paid to investors, “that income is going to be taxed as interest if it comes from the coupon on a bond,” Dickson says.

In addition, even some of the income dividends paid by stock funds, which totaled $21.5 billion in 2002, won’t qualify for the 15% rate, Dickson and other fund executives say. A portion of the income dividends paid by stock funds indeed comes from stock dividends that should qualify for the new 15% top rate that is set to be retroactive to the beginning of this year.

But part of those income dividends has also come from other types of income, such as short-term capital gains and interest earnings from bonds or cash reserves in the portfolios. Those other sources of income would continue to be taxed at ordinary income rates under the new package, though the top rate will decline to 35% from 38.6%, according to fund tax experts.

A further complication is that some types of stock dividends won’t qualify for the 15% rate. For instance, shares of most real estate investment trusts, valued for their high yields, will not qualify for the new tax break because REITs generally don’t pay corporate income tax.