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MAKING CENTS OUT OF THE NEWS
Blog #20
(May 27th, 2010)
THE GREAT BIG BUT
By Tom McAllister, CFP®
The best source of portfolio income is in high-quality, dividend-paying common stock - at least that what I was saying two weeks ago (Blog #18-10). What never made it out of my mind and into that blog message was the great big BUT attached to my advice, having to do with the looming, and very large, tax increase on dividends paid to individuals.
As things stand now:
The maximum tax rate on dividend income is currently 15%. That looks low - until one remembers the U.S. corporate income tax, now 34% on large companies. Out of every 100 cents of earnings, the corporation keeps 66 cents. Out of this, the corporation pays dividends (usually less than half its after-tax earnings). Assuming, for purposes of this discussion, a payout of 1/3 of the original corporate earnings, individual shareholders would receive a 33-cent dividend. (After the 15% individual income tax on the dividend, shareholders net 28 cents. (Do the math: Between the corporate and individual tax, the IRS captures 39 cents of each 100 cents of corporate earnings!)
What happens January 1, 2011:
The 15% limitation on dividends disappears next calendar year. Dividends will be taxable at ordinary income rates, as high as 39.6% for “the rich,” those with incomes over $250,000.
But, as they say on the TV promotions, “WAIT!” There are new taxes being imposed on top of the increase in the dividend taxation rate itself. Beginning in 2013, high earning taxpayers (singles over $200K and couples over $250K) will have a 3.8% Medicare tax levied on ALL investment income, including dividends, capital gains, and rents.
Do the math: Total income taxes (on a combined corporate and individual level), starting in 2013, will consume half of each dollar of corporate earnings. Most would call this confiscatory!
Equally alarming is the coming increase in the capital gains tax (rising to 20% beginning 2011). With the addition in 2013 of the Medicare tax, the effective tax rate on capital gains will be 23.8%!
While the majority of our readers are either retired, or in any case do not find themselves in the topmost tax brackets illustrated here, I want to point out this huge increase in tax is being imposed on our most productive and growth-inducing taxpayers, including the private small business owners who hold the key to our country's economic recovery and future growth.
What should one do?
Now:
High income taxpayers should accelerate as much income in 2010 as possible.
Going Forward:
In individual accounts, reduce high dividend investments in favor of capital gain investments. This could defer tax and possibly reduce total income below the $200K or $250K limit this year and subsequent years before investments are sold.
Wherever possible, stocks paying relatively high dividends should be held in tax-free accounts such as IRAs and other retirement accounts, or in tax-free family trusts and foundations.
Times are a'coming that will try investors' souls and tax planning strategies. Use this "big BUT" alert.as a signal to coordinate planning with your tax advisor and your financial planner. At McAllister Financial, we ask only that you heed the message, not "shoot the messenger"!
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