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.

Related Articles
  1. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  2. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  3. Investing Basics

    4 Things That Make a Stock a Safe Bet

    No investment is a sure bet, but you can reduce your chances of taking a loss by choosing fair-priced stocks with growth potential and low volatility.
  4. Stock Analysis

    The 5 Best Stocks That Pay Monthly Dividends (PSEC, LTC)

    Get the scoop on five of the best stocks that pay regular monthly dividends, offering investors looking for regular income dividend yields of up to 16%.
  5. Stock Analysis

    The Top Rated Dividend Paying Stocks for 2016 (ABBV, BA)

    Discover five of the top-rated stocks that pay investors solid dividends that you may want to consider adding to your investment portfolio in 2016.
  6. Investing News

    Hillary Clinton's Liberal Orthodoxy

    Clinton's economic agenda laid out in July is divided into three broad groups: strong growth, fair growth and long-term growth. And her overarching goal is to "give working families a raise."
  7. Investing News

    Bernie Sanders: Socialist or Liberal?

    Sanders' pitch centers on economic inequality in the U.S., which is both more severe than it is in other developed countries and, if current trends continue, projected to worsen.
  8. Mutual Funds & ETFs

    The 4 Best Indexes for Dividends

    Learn about some of the biggest dividend indexes in the marketplace and which niche of the dividend universe each of these indexes targets.
  9. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  10. Investing Basics

    How And Why Do Companies Pay Dividends?

    The arguments for dividends include the idea that a dividend provides certainty about a company’s well being.
  1. How Long Should I Keep My Tax Records?

    The Internal Revenue Service (IRS) has some hard and fast rules regarding how long taxpayers should keep their tax records. As ... Read Full Answer >>
  2. Are personal loans tax deductible?

    Interest paid on personal loans is not tax deductible. If you take out a loan to buy a car for personal use or to cover other ... Read Full Answer >>
  3. Does a Flexible Spending Account (FSA) cover braces?

    Funds from a Flexible Spending Account (FSA) can be used to cover costs associated with installing, maintaining and removing ... Read Full Answer >>
  4. Does QVC charge sales tax?

    QVC, an American TV network, is registered with states to collect sales or use tax on taxable items. QVC is also required ... Read Full Answer >>
  5. Does a Flexible Spending Account (FSA) cover glasses?

    The funds in a Flexible Spending Account (FSA) can be used to cover most common medical expenses; this includes the cost ... Read Full Answer >>
  6. Are tax brackets adjusted for inflation?

    Each year, the U.S. Internal Revenue Service (IRS) adjusts tax brackets for changes in the cost of living to calculate federal ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center