Americans are benefiting from some of the lowest dividend and capital gains tax rates in the nation's history.  But that is scheduled to change -- and investors should be planning now for what is likely to happen in 2011. The good news is that there are a number of tax-savvy investment choices for protecting your hard-earned income.       

A Little Background
On May 28, 2003, President Bush signed into law the "Jobs and Growth Tax Relief Reconciliation Act." One provision of this law was to reduce the tax rates on certain dividends from as high as 38.6% down to 15%.

Another was to reduce the top tax rate on long-term capital gains (assets held more than one year) from 20% down to 15% as well. For taxpayers in a 15% or lower income tax bracket, the dividend tax rate was just 5% and, along with the capital gains tax, moved to 0% in 2008.

These tax rate cuts were slated to expire on December 31, 2008, but in May 2006, Congress voted to extend them by two more years. As a result, the provisions are now set to expire after December 31, 2010. Unless Congress renews or changes them, dividends will again be taxable as ordinary income, now up to 35%. Capital gains will also be taxable at the top rate of 20%.

What Should be Your Strategy Going Into 2010?
With potentially only two-and-a-half more years of reduced taxes, now is a good time to start planning on a tax-savings strategy beyond 2010.

For starters, if you don't have a tax-advantaged type of account, 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.

Some income investments that currently offer tax-advantaged income may lose their appeal as the higher 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.

Once the playing field is leveled and these securities are no longer seen as tax-disadvantaged, they may look more attractive to investors.

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. When you sell the shares, the return of capital you received is subtracted from your original purchase price. The difference between the share price and the lower cost basis will be taxed at the lower capital gains rate.

For example, if you bought shares for $20 a piece and received $5 in return of capital, your cost base would be $15. If you sell the shares for $25 each, you're taxed on the $10 per share capital gain ($25 less $15). If you sell the shares at a loss below your revised cost basis, you're income isn't taxable.

Suppose your returns of capital were higher than your purchase price. Let's say you received $21 in return of capital on your $20 per share purchase. When you sell the shares for $25 each, you'll be taxed on $26 per share in capital gains ($1 plus $25).

Closed-end funds with managed distribution policies (that distribute income at a fixed rate) typically include returns of capital in their distributions. But you have to avoid funds that aren't eroding their asset base with these payments.

But companies organized as trusts and partnerships generate cash flow that's also 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) are well worth considering.

Typically, MLPs pay out around 75-90% of their distributions 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.

With tax law changes looming on the horizon, High-Yield Investing editor Carla Pasternak has prepared a list of some of her favorite MLPs that you can start investing in now to avoid the potential tax bite after 2010. Best of all, these securities come with yields of 9%  and higher.  

To learn more about High-Yield Investing, and to learn more about these tax-savvy partnerships,  please visit this link.