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How to Handle the Coming Tax Hikes

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The market's correction over the past couple of months shows just how worried investors are about the global economy. But with huge tax increases potentially just months away, you need to start anticipating their possible effects now, before others beat you to the punch.

Doing a 180
Just a few years ago, the tax situation could hardly be better for most investors. Ordinary income tax rates had steadily fallen throughout the decade. Many dividends qualified for the same preferential rates that long-term capital gains enjoy. Those who were in the 15% tax bracket or less didn't have to pay any tax at all on qualified dividends and capital gains.

The catch is that these tax provisions were set to expire at the end of 2010. Everyone assumed that they'd be renewed in some form. But as the experience of the still temporarily repealed estate tax has shown, counting on lawmakers to pick up the ball is a dangerous proposition.

As a result, changing tax rates could have an impact on investor behavior both in the next several months, and for years to come. Let's take a look at what you can do to anticipate changes.

Problem: Higher overall rates will increase overall tax burdens.
Solution: Maximize use of retirement accounts.
Those who will likely be most affected by rate hikes are high-income taxpayers. They'll not only see top brackets rise from 35% to 39.6%; they'll also have to pay higher Medicare taxes in coming years, both as a surcharge to the existing rate on wage income as well as new levies on investment income.

The best remedy against high taxes is to take advantage of as many deductions as you can. If you're not maximizing the use of all available retirement accounts, whether they be IRAs or 401(k) plan accounts, then you're leaving money on the table for Uncle Sam to grab. Building those balances doesn't just reduce your taxable income now; it also gets more of your future income into a tax-sheltered account that could reduce your tax liability substantially throughout your career.

Problem: Capital gains rates are going up.
Solution: Consider harvesting gains sooner than later.
Ordinarily, incurring tax before you have to isn't smart. But with capital gains rates going up, the tax cost of selling stocks that have gone up in value will be more expensive next year.

So, if you have doubts about stocks, or you just see yourself needing the cash in the near future, then think about cashing in now. For instance, Akamai Technologies (Nasdaq: AKAM  ) and MercadoLibre (Nasdaq: MELI  ) hit new highs recently, having more than doubled in just the past year. But Akamai is vulnerable to trends that may reverse the huge expansion in bandwidth use in recent years. MercadoLibre trades at extremely high valuations, and while growth is still strong, there's no guarantee that online marketplaces can sustain that growth long enough to justify the company's stock price. Especially if you're already on the fence about selling a stock, a higher capital gains rate in future should be enough to tip you over the edge.

Problem: Dividend stocks will get taxed harder.
Solution: Prepare for falling payouts.
Until the past decade, dividends had been falling out of favor. Lower tax rates helped renew interest in dividends and spurred huge growth in companies' payouts. Microsoft (Nasdaq: MSFT  ) had never paid a dividend until the new tax laws took effect in 2003. Intel (Nasdaq: INTC  ) had made token payouts, but the company quadrupled its dividend in just two years once cheaper rates were available.

If dividend tax rates rise, then you can expect a reversal of that trend. Companies may not actively cut dividends for fear of it being misinterpreted as a sign of financial weakness, but growth may stop. If current fast-growing dividend payers PepsiCo (NYSE: PEP  ) and Colgate-Palmolive (NYSE: CL  ) stop pushing their dividends higher, investors who count on those increases may lose interest in the stocks, pushing share prices down.

Moreover, investors may decide that a big tax increase on high-yielding stocks makes them no longer worth the risk. Already, BP's (NYSE: BP  ) yield is approaching 10%, yet the stock has continued to fall with more bad news from the Gulf. If you see the taxes on those dividends more than double, you'll be less likely to want to hold onto them.

Escape the IRS
Taxes are a fact of life, but you shouldn't pay more than you have to. More importantly, others will eventually pick up on the coming problem and take action. If you act first to protect yourself, you'll have a key advantage.

Don't just sit there. Use the Fool's Tax Center to learn more about getting your taxes as low as they'll go.

Fool contributor Dan Caplinger may avoid higher taxes, but he thinks they're a bad idea right now. He doesn't own shares of the companies mentioned in this article. Intel and Microsoft are Motley Fool Inside Value recommendations. Akamai Technologies and MercadoLibre are Motley Fool Rule Breakers picks. PepsiCo is a Motley Fool Income Investor recommendation. The Fool has created a covered strangle position on Intel. Motley Fool Options has recommended buying calls on Intel and diagonal call positions on Microsoft and PepsiCo. Try any of our Foolish newsletters today, free for 30 days. With the Fool's disclosure policy, you can handle the truth.


Read/Post Comments (1) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 09, 2010, at 7:58 PM, stokker3 wrote:

    So, you are suggesting that shareholders should get out of awesome, dynamic growth stocks with incredible long-term potential (like MELI) simply because capital gains rates are going to tick up? I find this incredibly silly and short-sighted. MELI is hardly "over-valued" as you say. I assume that you are simply looking at the P/E ratio, which is literally the worst way to evaluate a young, fast growing company. I guess this means that you disagree with William O'Neil's IBD ranking of #6 then?

    Based on its' growth rates, marketplace, business opportunites, growth of the online user community in Latin America, etc. I could not possibly disagree more with your assessment.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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