How to Hide from the Dividend Tax Increase

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 the lowest 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 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 to as high as 43.4% by 2013 (39.6% regular tax rate starting in 2011 + 3.8% added healthcare tax).

Most expect Congress to tackle the issue. However, 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 yields 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 — no matter what happens with tax rates.

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 investment to earn the same after-tax income.

[See Rule #5 of my 5 Rules Every Income Investor Should Know]

So here’s a simple way to calculate your taxable equivalent yield when considering muni funds that might meet your needs. Divide the yield 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%

That means you’d have to find a fully-taxable yield of 9.7% to earn the same amount on an after-tax basis.

Of course, budget deficits across the United States 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 in 2010, according to the Center for Budget and Policy Studies.

Action to Take –> 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.

And even with a lower headline yield, the taxable equivalent yield of these funds should still be mouth-watering to investors — especially ahead of increased dividend taxes on other securities.

P.S. —The deadline for these tax changes is December 31st — just a few months away. If you want to get a jump on the situation now, you might like my “Income Security of the Month” for September. It’s a municipal bond fund that could soon carry a taxable-equivalent yield of 11.8%. Go here to learn more.