Just as the year 2013 was getting under way, Congress spent a few sleepless nights in Washington and approved a bill to help the nation from completely falling off the fiscal cliff that would have seen Bush-era tax cuts expire completely and boost taxes on all working Americans. The intimate details of the agreement reached between republicans and democrats in both the Senate and House of Representatives, along with nudging and input from the president, are still forthcoming, but the general framework is already known.
SEE: Fiscal Cliff Implications For Year-End Tax Planning
Specifics of the Agreement
Based off of the agreement that was signed during the waning hours of Jan. 1, taxes will be going up for individuals making more than $400,000 and couples with more than $450,000 in an annual adjusted gross income. This category of high-earning Americans will see the top marginal tax rate revert to 39.6% from 35%, or back to Clinton-era tax rates of more than a decade ago. There are also important caps on deductions and exemptions for individuals and couples making more than $250,000 and $300,000, respectively.
SEE: Tax Tips For The Individual Investor
In regards to investment-related tax changes, capital gains and dividend tax rates are estimated to increase from 15 to 20%, which applies to the higher categories of individuals with an annual income above $400,000 and couples above $450,000. This is much lower than worst-case predictions, but still represents a tax increase of 33.3% from previous levels.
Corporations Already Adjusted to Higher Dividend Taxes
Public companies did their best to help shareholders avoid the fiscal cliff and dividend tax increases by announcing special dividend payouts prior to the end of 2012. One source estimated that a typical fourth quarter will see around 30 special dividend payouts, but 2012 saw more than 230 announcements and payouts. Companies were worried that shareholders would see a drastic rise in dividend taxes that was estimated to revert back to personal income tax rates, such as the 39.6% rate being implemented for the highest earners.
Now Consider Shifting to Qualified Plans
The 5% increase is quite modest compared to some of the fears that were out there, but still should be addressed by the individuals who will now fall into the highest tax rate. Important strategies include shifting dividend-paying investments into qualified investment vehicles, or those that either defer taxes or shield assets from taxes completely. Tax-deferred plans include corporate 401(k) plans, individual retirement accounts (IRAs) while Roth IRAs mean taxes have already been paid and assets can grow tax-free. If at all possible, investors should shift from holding dividend paying stocks in non-qualified investment vehicles, such as taxable brokerage accounts, into these qualified plans.
Also Change Investment Strategies
Another viable strategy for these top earners is to shift away from investment strategies that emphasize dividend payments. This would have helped in the fourth quarter. An article in The New York Times estimated that utility and telecommunication stocks were the worst performers during the last quarter of 2012 because investors shifted out of stocks that paid the highest dividends. Again, the dividend tax increase was modest and means most investors will not have to worry about the higher tax rate on dividend payments, but the top earners could still employ this strategy.
SEE: Here's Why The Fiscal Cliff Deal Is Great News For Income Investors
An alternative strategy could be to focus on companies that grow earnings, which over time generally leads to a corresponding increase to their underlying stock price. Buying and holding these stocks could let unrealized gains build, which would avoid both dividend and capital gains tax rates. Focusing on qualified investment vehicles would also help defer, or avoid these taxes completely.
Investors could also focus on investing in municipal bonds, which generally help them avoid state and local taxes. The effective yield on municipal securities, which adds back the tax benefit of avoiding these taxes, currently compares favorably to the stock market's total dividend yield of right around 2.6%. The state yield on a municipal bond that has the highest rating and matures in 10 years is currently right around 2%, but would be higher when adding back an individual's state and local tax benefits.
The Bottom Line
As it stands, the increase in the dividend tax rate is only going to be about five percentage points and will affect a much smaller subset of individuals and couples than previously thought. If the United States had fallen completely off of the fiscal cliff, dividend taxes could have returned to regular income levels and affected nearly every working individual in the country.
Despite the more modest increase, there are still prudent strategies for individuals to take that will be affected by the higher dividend tax rate. In the long run, shifting to qualified investment vehicles and other viable investment strategies could help them defer, avoid or minimize the tax hike. Over many years of investing in stocks, these strategies could end up saving thousands or even hundreds of thousands of dollars.
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