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I don't want my readers being caught off
guard. January 1, 2011 could be one of the most important
dates in a long time for income investors.
As I discussed
last week, if Congress doesn't act by that date,
dividend taxes for most of us are going up. If you're in a
high tax bracket, the dividend tax could nearly triple!
Remember, beginning in 2011 the maximum tax rate will jump
from 15% to your marginal tax rate if Congress doesn't act.
This could mean the tax rate jumps as high as 39.6% in 2011
and 43.4% in 2013 when the added 3.8% healthcare tax kicks
in.
To make things as easy to understand as possible, take a
look at the table below. On the left are the current tax
rates for dividends based on your tax bracket. On the right
are the dividend tax rates in 2011 if nothing changes.
|
Tax Rates --
Current |
|
Tax Rates -- 2011 |
| Tax Bracket |
Dividend Tax |
Tax Bracket |
Dividend Tax |
|
10% |
0% |
15% |
15% |
| 15% |
0% |
28% |
28% |
|
25% |
15% |
31% |
31% |
| 28% |
15% |
36% |
36% |
|
33% |
15% |
39.6% |
39.6% |
| 35% |
15% |
|
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But these are just percents. The impact is
clearer if you see what it actually means to the dividends
in your pocket. Let's say you own 1,000 shares of a stock
that pays $3.00 per year. In total, you can expect a nice
sum of $3,000 from this investment. But that's before Uncle
Sam gets his cut.
Let's say you are in the top income tax bracket. Today, your
after-tax income looks like this:
$3,000 x (1-0.15) = $2,550 after taxes.
That means Uncle Sam gets to keep $450 of your dividend. But
let's fast forward to 2011 after the tax cuts expire. Your
after-tax income on that same investment would fall
dramatically:
$3,000 x (1-0.396) = $1,812 after taxes.
In other words, your $3,000 dividend turns into a handsome
payday for the government -- $1,188 to be exact.
For a $100,000 portfolio yielding 8% (which is the average
yield of my
High-Yield Investing portfolios), earners in the
highest tax bracket will see their after-tax income drop
from $6,800 to $4,832. That's a drop of nearly 30%
overnight.
Clearly, the impact of the dividend hike is more dramatic
for higher earners, but all income investors will be
affected. Because the tax brackets will revert to the level
before the Bush tax cuts, you can see from the chart above
that just about everyone will pay more than the current 15%
rate.
So to help you get ready, I've prepared some analysis of how
some of our favorite asset classes might be impacted if
dividend taxes increase...
High-Yielding Common Stocks
Lower tax rates helped to boost investor interest in
dividend-paying stocks and encouraged companies to increase
payouts. In 2004, the first full year after the tax cuts
were in place, 1,745 dividend increases were reported. An
increase in the dividend tax will likely have the opposite
effect. Companies may not cut their dividends, but dividend
growth might slow and fewer companies could initiate new
payments to investors. This situation might be offset by the
large amounts of cash currently being held by many
companies.
With higher taxes, those common stock dividends may also be
less attractive to many investors. And if companies stop
increasing dividends, those counting on predictable income
growth could sell, causing share prices to fall.
Real Estate Investment Trusts (REITs)
High-yielding securities that never qualified for the lower
tax rate, such as REITs, may enjoy renewed interest. Unlike
dividend-paying companies, REITs don't pay any taxes at the
corporate level. They are required by law to distribute the
majority of their earnings to investors. This means unless
earnings decrease, REITs can't simply cut payments.
More importantly, investors who shunned REITs because their
distributions are taxed as regular income may take a second
look, driving up share prices.
Master Limited Partnerships (MLPs)
Common stocks and REITs are not the only options for income
investors, and they won't be the only asset classes affected
by the tax increase. Master limited partnerships have been
an income darling -- most pay large distributions earned
from energy-related operations.
A majority of the cash MLPs distribute to investors is
considered a return of capital. Taxes on this type of
income are deferred until after shares are sold. Return of
capital is subtracted from the original purchase price
(lowering your cost basis), and when you sell, you are taxed
on your return from the adjusted basis.
With distributions that are more attractive compared to
common stocks, along with tax-deferred payments, MLPs like
Kinder Morgan (NYSE: KMP) could see renewed interest.
One caveat -- MLPs as a group have seen a tremendous run
thanks to their stable businesses and increasing dividends.
While I've held a few in my
High-Yield Investing
portfolio for some time, you need to be careful if you are
investing new dollars.
Municipal Bond Funds
It's nice to know that even if taxes on dividends rise,
there is still a place where you can earn tax-free
income -- municipal bonds and the funds that hold them. If
dividend taxes rise, municipal bonds (which are exempt from
federal taxes) should be one of the biggest beneficiaries.
One of the best ways to access these bonds -- and earn
higher yields -- is with muni bond funds. These funds can
hold a basket of bonds across all sorts of credit ratings.
This reduces the risk if an issue defaults and also leads to
higher yields.
Remember that you always want to calculate the
taxable-equivalent yield when looking at what a muni bond
pays. This way you get a more realistic picture of what you
need from a regular taxable investment to have the same
money after Uncle Sam takes his bite. To do this, simply
divide the yield by one minus your tax rate. So a 6%
tax-free yield would provide the same after-tax cash as a
fully taxed investment paying 9.9% (6%/(1-0.396)) for those
in the highest bracket.
Good Investing!
Carla Pasternak's Dividend Opportunities
P.S.-- If you're looking for dependable high
yields and tax-free monthly income, then you need to learn
more about my "Income
Security of the Month" for September 2010. When the
Bush tax cuts expire in just
115 days from
now, this muni bond fund could soon pay an eye-popping
"taxable-equivalent" yield of 11.8%. I've done a
ton of research on this opportunity and have put everything
you need to know to get started in
this special report.
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Related reading from Dividend
Opportunities...
There's another area where changing tax laws will have a big
impact: Canadian trusts. Come 2011, Canadian authorities
will tax their profits as regular income, possibly hurting
yields. See our take on the situation in
Don't Buy a Canadian Trust Until You Read This. |
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