A Painful Side Effect of Health Care Reform

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I know what you're thinking... But this isn't another article predicting which parts of the healthcare sector will be the most barren (or fertile) once the reform bill shakes out. There are plenty out there already -- and each of our StreetAuthority editors has already chimed in with a few thoughts.

This article isn't even about healthcare per se, at least not directly. Rather, I want to talk about a hidden provision that snuck in the back door during the reconciliation process, when certain "fixes" were made to push the bill through. Specifically, one that imposes a 3.8% surcharge on dividends and capital gains taxes.

I'm not here to draw lines in the political sand. But from an investing standpoint, this tax hike is insidious -- and could easily short-circuit this fragile recovery from the steepest stock market crash on record.

Let's not forget that profits are already taxed on the corporate level at 35%. What's left to distribute to shareholders is taxed again. In fact, this double-taxation is a big reason why rates were slashed back in 2001 to begin with. But enjoy that 15% rate now, because upper-income taxpayers will be saddled with a 20% tax next year and then a 23.8% rate soon after.

All things equal, if you're on the hook for $10,000 in annual dividends and/or capital gains taxes now -- brace yourself for a $15,867 bill in the near future. The $132 billion that is projected to be pulled from investors' pockets during the next decade will ostensibly help keep Medicare solvent. But who knows what the money will actually be spent on, since it will be deposited into a slush fund.

More importantly, raising the tax on dividends and capital gains will discourage investment and raise the cost of capital for businesses -- which in turn will stifle productivity and job creation. Unfortunately, history suggests it won't do much to bring in additional revenue either.

Believe it or not, taxpayers adjust their behavior to changing tax climates. And when higher capital gains taxes are on the horizon -- they sell, sell, sell to take advantage of the lower rate while it's still in effect. And then, once the inventory of unrealized gains is depleted, they sit tight.

The last time we saw a capital gains tax hike of this magnitude was an increase from 20% to 28% in 1987. Predictably, tax receipts jumped in 1986 just before the change took hold, but then they slumped and didn't return to their pre-hike levels for more than a decade.

When President Clinton lowered rates back down to 20% in 1997, we saw the opposite happen -- money began pouring into the Treasury. The same thing happened after rates were further dropped to the current 15% in 2003. In fact, the Wall Street Journal reports that revenues from capital gains spiked from $49 billion to $118 billion within four years.

Again, my point isn't to stir up a partisan debate. You can draw your own conclusions about whether the new tax policy is an economic roadblock or a step in the right direction. My intent is to let you know that changes are coming -- and it's never too soon to take pre-emptive portfolio action.

Going forward, I expect to see companies earmark more of their surplus capital for efficient stock buybacks rather than dividend increases. As for you, take steps to keep income-producing assets and high-turnover funds in IRAs and other tax qualified accounts.

And remember it's always a bull market for something. Punitive tax rates can do nothing but help one asset class -- municipal bonds.

Back in November 2008, I singled out three areas that stood to gain from the policies of newly-elected President Obama -- and one of those was tax-free munis. Investors are a pretty smart bunch and will adjust their playbook to take advantage of game-changing tax laws, going on offense when taxes are eased and defense when they are tightened.

You can bet that big investors will be looking to shield more of their income from Uncle Sam. If you live in a state with high taxes (and sound financial footing) it might make sense to consider a state-specific muni. Otherwise, a diversified portfolio of debt from around the country might be a better bet.

Like Blackrock Muni Intermediate ( MUI ) , a closed-end fund that offers exposure to a well-rounded basket of bonds issued by dozens of creditworthy agencies. The fund is trading at an attractive 4.3% discount to NAV , invests primarily in AA and AAA-rated securities, and offers a robust payout of 4.8 % -- for a tax-equivalent yield ( TEY ) of 6.8% for those in the 35% bracket. And it scores in the top decile of its peer group by outrunning nearly 90% of its category rivals during the past five years.

With April 15 less than two weeks away, there's no time like the present to begin preparing for the onslaught of higher taxes.


Nathan Slaughter
Editor: Market Advisor, The ETF Authority

P.S. If you're an income investor, you may want to check out my "High Income" portfolio over at The ETF Authority. Right now all 12 of my open recommendations are making money. On average they pay 7.2% in dividends and have generated total returns of +57.0%. To see how to get my next recommendation (which could be out in the coming days), you can go here.

Disclosure: Nathan Slaughter does not own shares of any security mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Bonds , Stocks

Referenced Stocks: MUI , TEY

Nathan Slaughter

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