As it stands currently, the tax rate on dividends that companies pay to shareholders will rise significantly at the start of 2013. The current tax rate on the vast majority of dividends (those that fit the definition of a qualified dividend) will jump from 15% to ordinary tax income rates. To add insult to injury, personal tax rates are also set to increase and that means the dividend tax rate will rise to roughly 43.4% at the highest rate, which breaks down to a 39.6% income tax rate and impending 3.8% tax on investment income that stems from new healthcare regulations. With this potential rise, here are three ways to try and offset the coming tax bite.
Shift to Retirement Accounts
One of the most straightforward ways to offset the impact of the higher tax hit on stock dividends is to shift the ownership of these stocks into accounts that offer tax advantages. An established Roth IRA is the most appealing as taxes have already been paid on the contribution and can grow tax-free going forward. Traditional individual retirement accounts (IRAs) offer tax deferrals after retirement and therefore many decades of avoiding tax payments on dividends. When the income is actually needed in retirement, tax rates will likely be much lower for individuals that are no longer working, provided the political climate is stable in the future and government finances are in good shape.
Shift to Growth
Capital gains rates are also set to rise at the start of 2013, but the rise will be more modest. Currently, the rate is set to rise from 15% to 20%, if nothing is done in D.C. A 33.3% rise is certainly significant, but it's less severe than a dividend income tax rate rising from 15% to ordinary income tax rates, especially for high-income earners.
From this standpoint, an investor could look to invest in companies with above-average earnings growth potential. Stock returns follow profit growth over the long haul and, if done correctly, would let the investor sell off the appreciated stock and use it to replace lost dividend income. It offers a better appeal from a tax perspective, and could end up increasing overall wealth. Another important point is that capital gains taxes are for stocks bought and hold indefinitely. This is because capital gains must be paid on realized gains, and not those that are unrealized over many years and allowed to build without paying a cent in taxes.
Return to Income
If dividends start to be taxed at ordinary income rates again, then from a tax perspective they will be identical for income generated from many types of bonds. For corporate bonds, the tax treatment will be the same. In this respect, corporate bonds will now be equal to dividends in terms of taxes and can be looked at more closely. The current yield on a 10-year corporate bond of the highest quality exceeds 4%, which is on par to the dividend yield of the highest yielding blue chip stocks. Clearly, the risk of rising interest rates and inflation also need to be considered for bonds, but from an income perspective it would be on par with stock dividends.
Other types of bonds will now be more appealing than dividends as they offer certain tax benefits. U.S. government bonds are generally only taxed at the federal level, as are certain agency securities, such as those from the Government National Mortgage Association (GNMA, or Ginnie Mae for short). Municipal bonds are even more appealing and can help an investor avoid federal, state and local taxes, provided he or she resides in the state or municipality of where the bond was issued. The 10-year municipal bond rate of the highest rated class is currently only 1.58%, but will be higher because the tax equivalent yield adds back what would have been paid out in taxes.
The Bottom Line
Many investors are holding out hope that Congress passes some extension of the current income tax rates. Optimists can't fathom how politicians would risk stifling the current economic recovery following the Great Recession, but the realities are that the record federal debt will need to be tackled as well. Overall then, it may pay to try and offset the potential tax hikes to company dividends.
More From Investopedia