Warning: New Tax Rules Will Ruin Your Dividend Income

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If Mitt Romney wins November’s election, then perhaps this article will be obsolete.  But better safe than sorry.

Current Dividend Rules

Through the end of 2012, qualified dividends are taxed at 15% and ordinary dividends are taxed at the ordinary tax rate.  However, the Bush tax cuts are set to expire at the end of 2012, creating a swarm of new tax increases.

For example, Congress may implement a new 3.8% surtax for high income earners.  Coupled with the tax increases, the raise could spell disaster for future dividend recipients.

The New Rules

If President Obama and Congress allow the Bush tax cuts to expire – and take no action to keep taxes low – then rates will see an immediate hike January 1, 2013.

At a minimum, it looks likely that taxes on dividends will be taxed somewhere between 18.8% and 43.4%, depending on Washington’s action.  The 3.8% surtax added to the current capital gains rate produces 18.8%.

However, it is possible that all dividends could be taxed at individuals’ 2013 ordinary income tax rates.  Those rates are 15%, 28%, 31%, 36%, and 39.6%.  If President Obama allows the cuts to expire and the surtax to pass, the highest earners could see taxes on dividends of 43.4%.

Taxes and Your Portfolio

Some companies pay dividends in January 2013 instead of 2012, when the lower rates still take effect.  Wal-Mart (NYSE: WMT), for example, has declared that its next dividend will be paid out in January of 2013.  Wal-Mart’s January dividend will total approximately $1.34 billion.

Those who own shares in General Electric (NYSE: GE) and Philip Morris International (NYSE: PM), which boast 3.5% and 3.9% dividends, respectively, face the same problem.  These two companies also pay out their next dividends in January instead of December.  If you own shares in either of these companies, consider if it makes sense to switch out of these securities or to keep them and roll the dice on Congress.

When faced with the prospect of its shareholders paying higher taxes, Sara Lee took an unusual approach:

Two years ago, when Congress also looked likely to jack up taxes on dividends, roughly two dozen companies, including Sara Lee, accelerated their January 2011 payouts into December 2010.

Some firms are considering this type of accelerated payment.  Sara Lee’s past example could spur companies to consider giving investors a break, by paying the dividend one month sooner. 

Great Dividends, Great Timing

With all the hoopla about Obamacare, I have been watching two healthcare companies, Johnson & Johnson (NYSE: JNJ) and Pfizer (NYSE: PFE) closely.  If you hold them in your portfolio, fear not!

Both of these companies pay their next dividend in December.  J&J pays part of its 3.4% dividend on December 11, and Pfizer pays the portion of its 3.5% dividend on December 4.  As an aside, J&J has hiked its dividend 49 years running, and Pfizer’s earnings and cash flow look to bode very well for the stock. 

Trimming the Tax Bill

If taxes on dividends see a major hike, investors can make a change going forward.  To trim the tax bill, here is a simple portfolio move – sell the dividend-paying assets and then buy them in a tax-deferred plan.  IRA assets, for example, face no tax consequences until withdrawn after age 59 ½. 

As an example, assume that your dividend portfolio represents 10% of your overall portfolio, and you hold the dividend-paying stocks in a taxable account.  Instead, holding your dividend-paying stocks in your IRA and holding the growth stocks in taxable accounts leave the overall portfolio unchanged – but the restructuring puts more money in your pocket because dividends in the IRA face no immediate taxes.

If your overall portfolio holds a stable of dividend-payers, consider the switch – however, first be absolutely certain to understand qualified dividends and how the move will affect your tax bill.  What you don’t want is a major tax bill now to save an immaterial amount next year.

Selling divided-paying stocks now could be a smart move.  It would either incur a loss, a short-term gain, or a capital gain.  If the sale incurs a loss, see if the wash sale rule applies, where you cannot deduct the loss and buy the security back within 30 days.  If a short-term gain applies, then you will likely be taxed at your income tax rate.  

However, if a capital gain applies, then you will pay 15% in tax. This could be advantageous for two reasons. First, capital gains rates will pop back up to 20% next year when the Bush tax cuts expire.  President Obama also called for a 20% rate.  Second, you will pay tax on the gains now, but will not pay the potentially increased tax on dividends or capital gains while the security is in your IRA.

I have found these two Wall Street Journal articles to be incredibly helpful.

  1. "Countdown to a Tax Hike"
  2. "Get Ready for the New Investment Tax"

Governor (President?) Romney

If Mitt Romney wins November’s election, investor fears will be eased.  Romney hopes to cut the capital gains rate to 0%.  While his plan with dividends is not set in stone, I would expect him to take a favorable approach to investors. 

Come January, the U.S. could see major tax increases at a trying time in the economy.  But come November, perhaps worrying about future tax hikes will be a distant memory.

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ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of General Electric Company and Johnson & Johnson. Motley Fool newsletter services recommend Johnson & Johnson and Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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