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Published: November 24, 2009
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 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 simply considered 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.
Carla Pasternak
Editor
High-Yield Investing
High-Yield International
Dividend Opportunities
P.S. If you're concerned about getting the maximum income stream
from your portfolio, then you need to read
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