If You Own Dividend Stocks and Are Worried About Taxes, Then Read This…

I recently shared an important piece of news with readers of my High-Yield Investing newsletter that I think every dividend investor should know about.

Last month, President Barack Obama tabled his $3.8 trillion budget for the 2013 fiscal year starting this October 1. The budget proposes $1.7 trillion in new revenue over the next 10 years, in part by ending Bush-era tax cuts for “wealthy” individuals making more than $200,000 in income and households earning more than $250,000 a year.
That’s nothing new. In a recent article, I talked about what Obama was proposing when tax cuts approved under George W. Bush expire at the end of this year.
What is new, however, is that for the first time Obama is proposing a dividend tax rate of up to 39.6% on the wealthy. Originally, the administration had said it would raise the top tax rate on qualified dividends from 15%, where they are today, to 20% for the wealthy.

Before I go further, let me say this… It’s not my intent to weigh in on the political debate, but rather to simply give you the information you need to know. Any time an important change is made to tax policy that will affect dividend investors, I feel it’s my duty to weigh in to readers of High-Yield Investing — and I think it’s certainly worthwhile for other income investors to hear about, too.
Now, the new budget calls for taxing the wealthy on dividends at the same rate as ordinary income. And the budget also proposes raising the top income tax rate from 35% to 39.6%. The administration says the dividend tax increase would pump $206 billion into federal coffers in the next decade.
The proposed long-term capital gains rate (on assets owned for at least a year) for the wealthy would rise, as originally planned, from 15% to 20%. Top earners would also incur a 3.8% surcharge included in the recently-passed federal health care reform law. That would bring the top dividend rate to 43.4% and the top capital gains rate to 23.8%.
Municipal bonds are also under the gun. The president’s budget seeks to cap the tax breaks on tax-exempt municipal bonds, which could reduce their appeal to top income earners. The top 35% tax bracket currently gets full tax deductions on municipal bond interest payments. Obama is now proposing to cap those deductions to the 28% marginal tax bracket. That means interest income above $83,600 for single filers and $139,350 for households would be fully taxable as ordinary income, no matter whether the interest is from tax-exempt munis or not.
The president also wants to reintroduce Build America Bonds (BAB) but cut the federal subsidy on them. Build America Bonds are essentially taxable municipal bonds that provide municipal governments with federal subsidies and tax credits. The government now pays 35% of the interest costs on these bonds, so municipalities can issue them at higher, more attractive rates. However, Obama would like to pay 30% for two years, and then cut the subsidy to 28%. The lower subsidies also could force municipalities to issue Build America Bonds at lower rates, making them less attractive to investors and harder for municipalities to raise money.
Risks to Consider: The consequences of the proposed budget could be unfavorable for income investors in the top tax brackets, even while the rest of us would continue to enjoy the top 15% rate on dividends and long-term capital gains and the full exemption of tax-exempt municipal bonds. But as I said in my previous take on this issue, “… most of us in the middle-income tax brackets shouldn’t be greatly affected by whatever tax changes take place. Still, the uncertainty will almost certainly lead to increased volatility.”

Action to Take –> There’s no point in jumping the gun. Regardless of whether you will be affected by these proposed changes or not, it’s not a reason to sell any of your income holdings at this point. It’s still a long way off from coming into law, at least before the election. Right now, it’s more a campaign platform than a legislative bill. But I’ll keep my High-Yield Investing readers posted in case anything changes and weigh in on how it will affect them. Stay tuned…