StreetAuthority Staff & Investing Experts

Time is running out.

Congress has 42 days to decide what they’re going to do about the “Bush Era” Tax cuts. If they don’t act by December 31st, income taxes will rise across the board.

Long-term capital gains could also increase. If the tax cuts aren’t renewed, capital gains rates could go up to as much as 20%. And for people in the top income (single filers making over $200,000 and $250,000 for join filers), you could also pay an extra 3.8% Medicare tax on all investment income.

In other words, the top tax rates could be as high 43.4% for dividends and 23.8% for capital gains.#-ad_banner-#

In recent issues of Dividend Opportunities, I’ve told you how you can escape the tax hikes by investing in tax-exempt municipal bonds. #-ad_banner-#

However you play it though, the tax hikes will affect some of our favorite dividend-paying companies. Right now, dividends and capital gains are both taxed at the same 15% rate. That could change. In the face of rising dividend taxes, companies could favor share buyback over dividend increases.

Both share buy-backs and dividends can support the share price. Dividends add value by distributing cash to shareholders. Buy-backs also add value. When mortgage trust Annaly Capital (NYSE: NLY) said on October 16 that the company would buy back up to $1.5 billion of its shares, the shares closed nearly 2% off their intraday low.

The response was not unique. Research consistently finds that small repurchase programs produce an average share price increase of 2%-3% on the day of the announcement. Larger buybacks of 15% or more of the shares see prices increase by an average 16%, according to a report by management consulting firm McKinsey & Company.

A few reasons are generally cited for the positive affect of buybacks on share performance. By reducing the supply of outstanding shares while demand remains intact, buybacks can boost the share price.

The reduced share count can also trigger an increase in per-share dividends, which in turn helps lift the share price. But above all, a buyback signals that management believes the stock is undervalued, and the buyback sends a particularly strong signal when management is personally buying shares.

Both dividends and buybacks reduce the value of the company’s equity by the same amount, but buybacks are more tax-efficient for individual investors.

For example, let’s say a company has two million outstanding shares trading at $10 a share, for a market cap of $20 million. It pays out $1.50 per share in dividends, for a total of $3 million.

The value of each share declines by the amount of the dividend to reflect the decrease in the company’s assets resulting from the dividend payout. Each share is now worth $8.50, giving the company a market cap of $17 million.

Instead, if the company were to use the same $3 million to buy back shares, it would have 300,000 fewer shares outstanding. That leaves 1.7 million shares outstanding, reducing the market cap by $3 million to the same $17 million.

However, taxes make a big difference. Under the new tax regime, investors could be taxed up to 43.4% on the dividends. They would get to keep just $0.85 per share ($1.50 * (1-0.434)). The rest goes to Uncle Sam. In contrast, investors who sell their shares back to the issuer and realize capital gains on the buyback would be taxed at most at the 23.8% rate.

Buybacks aren’t foolproof. If the stock is already fully-priced, for example, shareholders could take a capital loss if they sell the shares back to the company. If management uses buybacks to appear to raise per-share earnings by reducing outstanding shares, while not in fact increasing return on equity, the buyback can send a false signal to investors.

In any case, if dividends are taxed as ordinary income, you may want to consider high-yield stocks with tax-advantageous share buyback programs in the works.

With these points in mind, I ran a screen on my company’s Bloomberg terminal for companies with stocks yielding at least 5% that recently announced plans to buy back shares.

Here’s what I found…

To be fair, the shares of all of these companies have underperformed the S&P 500 over the past year thanks to dividend cuts, negative earnings surprises, management changes, or other reasons.

Action to Take –> Of all these companies, Annaly’s $1.5 billion buyback program, to take place over the next 12 months, is one of the largest and most rapid. It will reduce the share count by about 10%, which could help the company regain a more solid footing in a challenging low interest rate environment for mortgage REITs. With their double-digit yield, these shares are worth keeping an eye on.

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