Recent Tax Changes Favor Investors

As you may know, in 2003 legislation was introduced that effectively reduced the tax ceiling on dividend distributions to just 15% (from a top marginal rate of 38.6%). As expected, the move had an immediate impact, and dividends have enjoyed a strong rise in popularity ever since. In fact, three-fourths of all S&P 500 firms now make regular quarterly distributions, dishing out more than $250 billion to shareholders every year -- and that doesn't include smaller firms that belong to other indices.

However, as is usually the case, the new laws came with some fine print, and many investors have found out the hard way that not all dividend income qualifies for the reduced rate. For example, payments made by real estate investment trusts (REITs) are still taxed at ordinary income tax rates of up to 35%. Income from some foreign stocks also fails to qualify. And, of course, the new laws only cover dividend income, not interest income -- so any interest generated by CDs, savings accounts, fixed annuities, bonds, and other securities is still fully taxable.

Therefore, the distributions made by most income-oriented funds -- the majority of which either invest in bonds or a broad mixture of stocks, bonds, preferred shares, and other securities -- aren't fully entitled to the tax break. In other words, if a fund shareholder receives distributions totaling $1.00 per share, it's a safe bet that they might only wind up with $0.65 (assuming a regular income tax rate of 35%) or so after paying taxes. And depending on state taxes, they may keep even less than that.

Assuming the fund had a net asset value (NAV) of $10.00, the pre-tax yield would be a tantalizing 10.0% ($1.00/$10.00). However, as we all know, the true bottom line is really after-tax income, which in this case would be a more pedestrian 6.5% ($0.65/$10.00).

Fortunately, a whole new breed of closed-end funds has cropped up with a single purpose in mind -- to maximize after-tax income by focusing almost exclusively on stocks with dividends that qualify for the reduced 15% tax rate. To give you an idea of how popular these new funds have become, consider this: in 2006, Eaton Vance (a pioneer in tax-managed investing) raised $2.62 billion by launching a new tax-advantaged income fund -- the Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE: ETY). At the time, the launch ranked as the biggest closed-end fund initial public offering (IPO) in Wall Street history. And this is just one of many of these funds now on the market.

To provide a real world example of how these funds work, let's take a quick look at an example: Nuveen Tax-Advantaged Total Return Strategy Fund (NYSE: JTA). The fund currently offers quarterly distributions of $0.5075 per share, for an annual payout of $2.03 per share. All of that total consists of either qualified dividend income (QDI) or long-term capital gains -- which are both taxed at just 15%. 

If the entire distribution were taxed as ordinary income at the 35% rate, then shareholders would keep only $1.32 per share, and the rest would go to Uncle Sam. But since all of the distribution qualifies for the 15% dividend tax rate, investors would get to keep up to $1.73 per share of the total $2.03 distribution. That difference may not sound like very much, but if you own 10,000 shares, the $4,100 you'll save in taxes could pay for a very nice cruise. So you can see, it literally pays to invest in tax-advantaged funds.

The table below includes some of today's most prominent tax-advantaged closed-end funds. . .