The below article is no longer applicable as the dividend tax rates were kept at 15% for 2011 as a result of the recently passed extension to the Bush tax cuts.

How Much Will Tax Rates Increase?
As of now, the Bush tax cuts are set to expire which means that qualified dividends will be taxed at ordinary income tax rates.  More specifically, if you are at the 28% ordinary income tax bracket (single: $82.4K-$171.85K; joint: $137.3K-$209.25K), then you will be taxed 28% on dividend income.  As a reminder, the current dividend tax rate is 15%, so it would be going up 13% to 28% for this tax bracket.  For the highest income earners, the dividend tax rate could be 39.6%! Yikes!  BUT, and this is very important, lawmakers may step in & order a provision similar to what the Obama administration is advocating; limiting the dividend tax rate to a more manageable 20%.  Still, there are no guarantees as lawmakers never did anything with the “no 2010 estate tax debacle” (i.e. you could still die & not owe estate tax).

How Should I Prepare For the Tax Rate Hike?
Unfortunately, we do not have a secret recipe for you to follow because there is so much uncertainty as to the magnitude of the tax rate hike.  Given this fact, it would be prudent not to make any rash decisions because of what could potentially happen to tax rates.  In addition, tax rates are just one of the many factors you should consider when making an investment decision.  Still, we understand you want an answer so we’ve examined some factors & options for you to think about as you manage your portfolio for 2011.

Look for Replacements (i.e. MUNIS & REITs)
If you are one of the many Americans these days that rely on income generating stocks that pay dividends, then it’s also time to start thinking about Municipal bonds.  Municipal bonds are bonds issued by the city, county & state governments and are often seen as less risky investments than equities.  In addition, the investor is not subject to federal tax on the interest income & also wouldn’t have to pay state/local tax on the interest if the bonds are issued by the investor’s city, county or state.  The main drawback with municipal bonds right now & the bond market in general, is that interest rates are low & expected to increase over the coming years, so the value of a municipal bond investment will likely go down.  But, if you are really just looking to replace the income & benefit from tax savings, this type of investment deserves serious consideration.

Then there are also REITs.  Unlike other dividend paying stocks, REITs do not pay any taxes at the company level as they are required by law to distribute at least 90% of their profits to shareholders and they receive a dividend paid deduction for this amount.  As a result, dividend yields are usually in the mid to high single digit range which are generally superior compared to the rest of the market.  But, shareholders generally have to pay taxes on the dividend distributions at their ordinary income tax rates unless distributions are considered to be qualified dividends which would be taxed at capital gains rates, estimated to be 20% in 2011.  They can also make return of capital distributions which are non-taxable.

Think About the Tax Cost
If your portfolio is not comprised of a large percentage of dividend paying stocks, then it may not make sense to invest a lot of time & planning in preparing for 2011.  On the other hand, if you have a $1M portfolio, of which, 50% or $500K of the value is derived from high yield dividend paying stocks then you should invest in properly preparing.

Hedge Your Exposure
It is important to be cognizant that dividend paying stock prices would likely fall as a result of a significant tax rate hike.  It’s hard to say how much stocks will fall since, for one, we cannot predict whether the dividend tax rate will be 20% or 40% or something in between. On the other hand, we can definitely predict that a hedge will reduce your exposure.  What do we mean here?  If you sell some of your high dividend yield paying stock (not all) & put that money towards another dissimilar stock investment, you would be hedging your exposure.

More Dividend Tax Questions?

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