The Fiscal Cliff: Everything You Need to Know about Potential Investment Tax Changes


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The media frenzy surrounding the so-called fiscal cliff is reaching a crescendo, as politicians in Washington argue about how to handle impending tax cut expirations. Here's everything you need to know about the current taxes and how they could change.

History of the Tax Cuts

The Economic Growth and Tax Relief Reconciliation Act of 2001, which was passed by President Bush, made several changes to many tax rates including income tax, estate and gift tax exclusions, and retirement plan rules. The act increased the amount of tax exemption for individual Alternative Minimum Tax ( AMT ).

In 2003, President Bush passed the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) which extended tax cuts on AMT, and cut taxes for investors for individual rates, capital gains, dividends, and estate tax.

The tax on capital gains were reduced from rates of 8% to 15% to just 5% for individuals in the 0-15% tax bracket. The highest tax rate for capital gains was 15%. Under Bush's tax cuts, taxes on qualified dividends were lowered to capital gain levels.

In December 2010, President Obama put a two year extension on these policies, which are due to expire January 1, 2013. The potential expiration of these cuts has been dubbed the "fiscal cliff."

Capital Gains Taxes

Capital gains are the profit made from the sale of capital assets, which can be stocks, bonds, or real estate. This profit is considered investment income, and is subject to special tax rates.

Bush's 2003 tax cuts reduced the tax rate for capital gains to 0% for the bottom two tax brackets, and 15% to all other tax brackets. If congress is unable to make an agreement, tax rates will significantly increase from the 15% tax rate.

The tax rate on capital gains is expected to increase to 20% if current cuts are allowed to expire, with an additional 3.8% healthcare tax for individuals who earn more than $200,000 per year, or a couple who earns $250,000 per year.

Tax on Qualified Dividends

Qualified Dividends are dividends which are taxed at the same level as capital gains. This level, which is usually lower than regular income tax, applies to regular dividends paid by most U.S. corporations.

Investors are required to hold a common stock for more than 60 days during the 120 day period before the ex-dividend date in order to receive the qualified dividend tax rate. Holders of preferred stock are required to hold the stock for 90 days during the 180 day period during the 90 days before the ex-dividend date.

Dividends of foreign corporations may also be considered qualified dividends if they trade on a U.S. exchange.

The following chart shows the current qualified dividend tax implications, as well has the potential increases planned for January if no agreement is made.

Qualified Dividend Taxes

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Tax on Non-Qualified Dividends

As shown below, non-qualified dividend are taxes equal to an individual's regular income tax rate. Non-qualified dividends include payouts from real estate investment trusts (REITs), master limited partnerships (MLPs), dividends paid by tax exempt companies, dividends paid on employee stock options, and dividends paid on savings or money market accounts.

Even if a company is qualified for regular dividends, special dividends do not qualify for the special tax rate.

Since regular income taxes are expected to increase in January, taxes on non-qualified dividends will also increase with income taxes if there is not an agreement.

Non-Qualified Dividend Taxes

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Possible Tax Reform Scenarios

As we wait for the president and congress to come up with an agreement, many are wondering what actually may occur after politicians come to a resolution. The government has essentially four options to choose from: extending the Bush tax cuts, let the tax cuts expire and not replace them, tax only the rich, or come to a compromise. Let's examine these four scenarios.

  1. Kick the Can - The government approves another extension onto Bush's tax cuts. This is what Republicans are hoping for - continuing with current tax rates, and avoid the "fiscal cliff" altogether. Obama already extended these tax cuts once before in 2010.
    Likelihood: Somewhat Likely

  2. Do Nothing - If the government doesn't do anything and simply allows the tax cuts to expire, all income, capital gains, and dividend taxes return to the rate that they were prior to Bush's 2003 tax cuts. This scenario would be the worst choice for everyone involved. Not acting on this situation would hurt individuals, government, corporations, and the markets.
    Likelihood: Extremely Unlikely

  3. Punish Only the Rich - Obama is pushing for a policy which would target individuals earning over $250k, while giving individuals in lower tax brackets continued tax breaks. Republicans oppose this scenario, hoping for a compromise to tax more than just the wealthy.
    Likelihood: Likely

  4. Some Combination of #1 and #3 - Government makes compromise to let all multiple brackets share the burden, and not just leave it all to the rich. This scenario would raise taxes somewhat on the rich, but not put all the excess tax obligations on those individuals.
    Likelihood: Very Likely

The Bottom Line

The chance of the Government doing nothing about the fiscal cliff is highly unlikely. Although there is no way to know for sure, there is almost zero chance that the government will just allow the tax cuts to expire. There are plenty of other options to explore, and letting the cuts expire would be pretty disastrous.

Even if a resolution is not reached by the end of 2012, don't panic. Any subsequent changes can always be made retroactively. "The Myth of the Cliff" makes the public believe that if an agreement is not made by January 1, an economic catastrophe will ensue. Although a lack of resolution would certainly hurt the economy, the deadline to reach a resolution is not actually January 1.

Finally, no matter what the environment, investors must always invest wisely. It is important that investors do not make investment decisions based on taxes. Interest rates are still historically low, making dividends an ideal investment choice. This fact will not change, regardless of potential tax changes in Washington.

Be sure to visit our complete recommended list of the Best Dividend Stocks , as well as a detailed explanation of our ratings system here .

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

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