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. [See: How to Hide from the Dividend Tax Increase] 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.
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, but 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.
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 and drive 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.
It's nice to know that even if taxes on dividends rise, there is still a place where you can earn tax-free income from 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.
Action to Take --> 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 would need from a regular taxable investment in order to have the same amount of 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.