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On May 28, 2003, former President Bush signed into law the
Jobs and Growth Tax Relief Reconciliation Act. One
major provision of this law was to reduce the tax rates on
certain dividends from as high as 38.6% down to 15%.
But unless this tax break is extended, which seems unlikely,
dividend rates are going up come 2011.
In fact, the Obama Administration submitted its budget
blueprint for 2010 just a few months ago. Within it is was a
proposal to permanently extend the Bush tax cuts on
dividends and capital gains for earners making below
$250,000 (married filing joint returns) and $200,000
(single). But it also proposed raising the tax rate
to 20% for those earning above the $200,000/$250,000
threshold.
Just to be clear, I'm not taking sides. I'm simply trying to
prepare you for what could potentially lie ahead. And it
looks the tax rate on dividends for some investors is going
to go up.
But that doesn't mean you have to give up income investing
if you are in a higher tax bracket -- there are places you
can shelter yourself from dividend taxes. Best of all, we've
found one spot any investor can earn
tax-advantaged income... even if they aren't fortunate
enough to be earning more than $200,000.
What Should be Your Strategy Going Into 2011?
With just months left before the potential changes, now is a
good time to start planning on a tax-savings strategy.
For starters, if you don't have a tax-advantaged account
like an IRA, you may want to consider setting one up in
preparation for the higher rates. This account will allow
you to take advantage of solid securities that don't offer
tax-advantaged dividend income.
And keep in mind that some income investments currently
offering tax-advantaged income may lose their appeal as the
higher tax rates kick in. Other high-yielding securities
that never qualified for the lower dividend rate, like real
estate investment trusts, bond funds, or preferred stock,
may attract renewed interest.
Tax-Advantaged Yield for a Post-2010 World
But what if you've reached your contribution limit on your
tax-advantaged IRA account? Sure, you can load up on
tax-exempt municipal bonds and the funds that hold them. But
that's not all. You also can turn to securities that pay out
large doses of
return of capital.
Return of capital is considered simply a return of your
original after-tax investment. Therefore, it's not taxed,
but it does lower your cost basis. This means you don't have
to pay taxes on the income received until after you sell the
shares. When you do sell, the return of capital you received
is subtracted from your original purchase price.
For example, if you bought a stock at $20 and received $5 in
return of capital, your cost basis would be $15. If you sell
the shares for $25 each, you're taxed on the $10 per share
capital gains ($25 less $15). Of course, if you sell the
shares at a loss below your revised cost basis, you're
income isn't taxable.
But where can you find companies that offer returns of
capital?
Companies organized as trusts and partnerships generate cash
flow that's considered return of capital. These payments
reflect depreciation and other non-cash items, so they don't
grind down the asset value. Rather, the return of capital
payments are simply a way to pass along cash flow to
investors.
For income investors seeking tax-advantaged return of
capital payments,
master limited partnerships (MLPs) like Plains All
American (NYSE: PAA) are well worth considering.
Typically, MLPs pay out around 75-90% of their distribution
as tax-deferred return of capital. The balance is treated as
taxable income, even in an IRA-type of account. For that
reason, MLPs are suited for a taxable brokerage account.
The nice thing about these partnerships is that even if you
aren't subjected to higher tax rates, you are still able to
put off most of the taxes until you sell the security -- so
they make a good idea for nearly any income investor.
Good Investing!
Carla Pasternak's Dividend Opportunities
P.S.
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