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 lower tax brackets even reached as low as
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 on 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 as high as 43.4% (39.6% regular tax
rate + 3.8% added healthcare tax).
Most expect Congress to tackle the issue -- starting as soon as
after the Easter break. But 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
can earn tax-advantaged income... no matter their tax bracket.
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 .
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
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
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 corporate bond to earn
the same after-tax income.
So here's a simple way to calculate your taxable equivalent yield
when considering muni funds that might meet your needs. Divide the
yield offered by the muni fund by 1 minus your marginal income tax
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) =
Of course, budget deficits across the U.S. 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 of an average 28% of total budgets in 2010,
according to the Center for Budget and Policy Studies.
Still, 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.
In addition, you can also find bond fund portfolios with other
built-in safety measures such as refunded or insured bonds.
A refunded bond is secured by a U.S. Treasury or similar risk-free
security. The Treasuries are held in an escrow fund and mature when
principal and interest payments on the munis are due. This strategy
adds a layer of security, but reduces the average yield on the
Insured munis are guaranteed to pay interest and principal on the
scheduled dates. If the issuer defaults, the insurer steps in and
makes the payments to the bondholder instead. This guarantee makes
these bonds virtually risk-free, but it does lower the yield.
But remember, even with a lower headline yield, the taxable
equivalent yield (especially ahead of increased dividend taxes on
other securities) of these bonds should still be mouth-watering to
Editor: High-Yield Investing, High-Yield International, Dividend
P.S. Ahead of any dividend tax changes, I covered two municipal
bonds in my April issue of High-Yield Investing. Both funds offer
taxable-equivalent yields of 10.0% or more for investors in the 28%
tax bracket. Follow this link to learn how to sign-up for
High-Yield Investing risk free and receive April's issue.
Disclosure: Carla Pasternak does not own shares of any security
mentioned in this article.
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