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Taxes pose a constant threat to investors and their returns. Now, after a 10-year period in which taxes on investors have dropped significantly, it looks like that trend is finally turning around. If you make the right moves now, though, you can avoid some of the pain that will come from higher taxes -- and perhaps also sidestep investment losses as well.
A decade ago, many Americans faced substantially higher income tax rates. The lowest tax bracket was 15%, rather than the current 10%; it proceeded directly to 28% instead of 25%; and it topped out at almost 40%, versus the 35% that top-bracket taxpayers pay today. A top rate of 20% applied to capital gains, and dividend income was taxed at the same higher rate as most other types of income.
Looking to the future, though, it's almost certain that higher taxes are coming. The recently passed health-care bill included a higher Medicare payroll tax rate for some taxpayers earning $200,000 or more, and tax rates for most forms of income are set to revert back to those 2000 levels at the beginning of next year if the government takes no action to change them.
Higher tax rates won't just increase the amount you pay to the IRS. They'll also make certain types of investments more attractive than others. To protect yourself, you should be thinking now about making portfolio changes to beat the rush once higher taxes actually take effect. In particular, you can read about three important factors to consider below.
1. The rise and fall of dividends?
Not long ago, dividend-paying stocks were almost considered outdated investments. From a tax perspective, dividends were inefficient; corporations had to pay tax on their income, and if they paid out that income in the form of dividends, their shareholders had to pay another layer of tax on their dividend payments. In response, companies tended to use stock buybacks and other methods of enhancing shareholder value without creating a bigger tax burden.
When the lower 15% maximum rate on qualified dividends arrived, though, dividends got a lot more popular. After Enron, Worldcom, and the myriad other accounting scandals of the early 2000s, shareholders felt a lot more comfortable getting cash directly from their companies. And with many companies having failed miserably in timing their stock buybacks, you might well feel more comfortable making your own decisions about whether to reinvest dividends in additional shares, or take the cash and run.
If tax rates rise, dividends might well fall out of favor again. It's unlikely that even high-yielding stocks like AT&T (NYSE: T ) , Altria (NYSE: MO ) , and BP (NYSE: BP ) would cut dividends, since such cuts are considered a negative sign about a company's financial health. However, dividend growth could slow or stop as companies seek more tax-efficient uses for their retained profits. In addition, shareholders trying to reduce their tax burden might get rid of dividend-paying stocks in favor of those that rise in value via capital appreciation.
2. Gimme (tax) shelter
Rising rates increase the rewards from tax shelters. As taxes increase, you'll have a bigger incentive to max out tax-favored investments like IRAs and employer-sponsored 401(k) plans.
In particular, going ahead and paying low rates now by converting existing retirement accounts to Roth IRAs might end up being your best move. Loading up your Roth with the stocks that you believe have the most potential -- big-growth prospects that resemble what Amazon.com (Nasdaq: AMZN ) and Green Mountain Coffee Roasters (Nasdaq: GMCR ) looked like years ago -- will bring you the biggest payoff if you own them inside a tax-free Roth.
3. Go long
Investors can control when and how they pay their taxes on the stocks they own. When tax rates are low, it's less costly to trade frequently.
But as tax rates rise, buy-and-hold investing makes a lot more sense. That increases the attractiveness of companies that are stable and solid enough to warrant a long-term investment -- profitable companies such as Coca-Cola (NYSE: KO ) and McDonald's (NYSE: MCD ) , for instance, which have dependable streams of revenue and income. They should become even more popular as higher taxes punish frequent traders.
Similarly, fund investors may well abandon high-turnover funds for ETFs and index funds, which often prove to be the most tax-efficient choices. Passive investing generally brings a lower tax bill, and you have a lot more control over when you decide to cash in your profits and turn over your fair share to the IRS.
No one likes a bigger tax bill. If you plan for higher taxes beforehand, though, you'll have the best chance to come out relatively unscathed. Getting the jump on other investors is essential to minimizing the potential damage to your portfolio.