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.

SEE: How Your Tax Rate Is Determined

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.

Related Articles
  1. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  2. Investing

    3 Cheap Dividend Growth Stocks for Your Portfolio

    Top dividend growth stocks to add to your portfolio.
  3. Investing

    The Pros and Cons of High-Yield Bonds

    Junk bonds are more volatile than investment-grade bonds but may provide significant advantages when analyzed in-depth.
  4. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  5. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
  6. Investing News

    Silicon Valley Startups Fly into Space

    Space enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
  7. Taxes

    How & Where to File Form 1040 (And Which Version)

    All taxpayers need to know three things when filing a 1040: which form to use, how to file and where to file. After reading this, you'll know all three.
  8. Savings

    Should You Look at 529 Plans Outside Your State?

    529 savings plans are not restricted by geography. So if your in-state offering has high fees or poor investment choices, look elsewhere.
  9. Taxes

    The Purpose Of The W-9 Form

    The W-9 form provides key data your clients need if you're an independent contractor. Just be sure you're not really an employee who should fill out a W-4.
  10. Retirement

    Pros and Cons of Deferred Compensation Plans

    Learn about the pros and cons of non-qualified deferred compensation (NQDC) plans, including the flexibility of non-ERISA plans and the potential for forfeiture.
  1. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  2. Do financial advisors charge VATs?

    The Personal Finance Society (PFS) and with Her Majesty's Revenue and Customs (HMRC) have outlined when a value-added tax ... Read Full Answer >>
  3. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  4. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  5. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  6. Are Cafeteria plans subject to FICA, ERISA or FUTA?

    Cafeteria plans are employer-sponsored benefit plans that provide both taxable and nontaxable, or qualified, benefit options ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center