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In 2003, former President Bush signed into law the Jobs
and Growth Tax Relief Reconciliation Act. One major
provision of this law was to reduce the tax rates on certain
dividends from nearly 40% for the highest income earners
down to 15%.
The dividend tax rate for lower tax brackets even reached as
low as 0%!
For us income investors, this tax break was a welcome sight.
But the cuts were passed with the provision that they expire
at the end of 2010. With the nation heavily in debt and
having run large deficits for the past several years, it's a
foregone conclusion among the investment community that
these dividend tax rates will have to rise.
Just to be clear, I'm not taking sides. I'm simply trying to
prepare you for what could lie ahead.
President Obama has proposed only increasing the dividend
tax rate to 20% for families making over $250,000. However,
the recent healthcare package already tacks on a 3.8% tax on
investment income for this group starting in 2013.
In other words, the highest earners would pay 23.8% (still
below the tax rates before Bush's tax cut) on dividends in a
few years. The current 15% tax rates for lower income
earners would be extended under Obama's proposal.
But that's where things get cloudy.
If Congress fails to act and the Bush tax cuts expire, then
dividends will revert back to being taxed as ordinary income
-- no questions asked. This means the dividend tax for
investors in the highest tax bracket would rise as high as
43.4% (39.6% regular tax rate + 3.8% added healthcare tax).
Most expect Congress to tackle the issue -- starting as soon
as after the Easter break. But in today's climate, you
should know that no legislation is a slam dunk.
But that doesn't mean you have to give up income investing
if you are in a higher tax bracket -- there are places you
can shelter yourself from dividend taxes. Best of all, I've
found one spot any investor can earn
tax-advantaged income... no matter their tax bracket.
What Should be Your Strategy Going into 2011?
With just months left before the potential changes, now is a
good time to start planning on a tax-savings strategy.
For starters, if you don't have a tax-advantaged account
like an IRA, you may want to consider setting one up in
preparation for the higher rates. This account will allow
you to take advantage of solid securities that don't offer
tax-advantaged dividend income.
And keep in mind that some income investments currently
offering tax-advantaged income may lose their appeal if the
higher tax rates kick in. Other high-yielding securities
that never qualified for the lower dividend rate, like real
estate investment trusts, bond funds, or preferred stock,
may attract renewed interest.
Tax-Advantaged Yield for a Post-2010 World
But what if you've reached your contribution limit on your
tax-advantaged IRA account? Luckily, there is a highly
tax-advantaged source of yields still available ...
municipal bonds.
Municipal bonds -- "munis" for short -- are issued by states
and municipalities to build schools, repair roads, and even
construct sports stadiums. Payments aren't taxed at the
federal level. In other words, you put yourself in the "0%"
tax bracket for your municipal dividends.
At first glance you might look at
municipal bonds and dismiss them as low yielding. But don't
be so quick to conclusions. Instead, you need to study a
muni bond's "taxable equivalent yield" -- the amount you'd
have to earn on a fully taxable corporate bond to earn the same
after-tax income.
So here's a simple way to calculate your taxable equivalent
yield when considering muni funds that might meet your
needs. Divide the yield offered by the muni fund by 1 minus
your marginal income tax rate.
In other words, if a muni bond pays 7% and you're in the 28%
tax bracket, your taxable equivalent yield is 9.7%:
7.0%/(1-0.28) = 9.7%
Of
course, budget deficits across the U.S. can weigh on muni
bonds. States like California have serious budget
shortfalls. The same is true for New York and Illinois. In
all, more than 40 states will have budget deficits of an
average 28% of total budgets in 2010, according to the
Center for Budget and Policy Studies.
Still, one way to protect yourself is by finding muni funds
with an investment-grade portfolio of at least "BBB-." The
diversification of a fund's municipal bond portfolio also
offers an additional layer of safety.
In addition, you can also find bond fund portfolios with
other built-in safety measures such as refunded or insured
bonds.
A refunded bond is secured by a U.S. Treasury or similar
risk-free security. The Treasuries are held in an escrow
fund and mature when principal and interest payments on the
munis are due. This strategy adds a layer of security, but
reduces the average yield on the fund's holdings.
Insured munis are guaranteed to pay interest and principal
on the scheduled dates. If the issuer defaults, the insurer
steps in and makes the payments to the bondholder instead.
This guarantee makes these bonds virtually risk-free, but it
does lower the yield.
But remember, even with a lower headline yield, the taxable
equivalent yield (especially ahead of increased dividend
taxes on other securities) of these bonds should still be
mouth-watering to investors.
Good Investing!
Carla Pasternak's Dividend Opportunities
P.S. -- Ahead of any dividend tax changes, I covered two
municipal bonds in my April issue of
High-Yield
Investing. Both funds offer taxable-equivalent
yields of 10.0% or more for investors in the 28% tax
bracket.
Follow this
link to learn how to sign-up to High-Yield
Investing risk free and receive April's issue.
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