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Only a few short weeks ago, many investors feared that big changes in the tax laws could make many of their investments a lot less attractive. But now, Congress has given you a lot more certainty on the tax front going forward, and by making the right investments, you can make the most of what lawmakers have given you.
What you need to know this tax season
With the looming expiration of some major tax breaks last year, you were right to be scared about what could have happened. Without action, tax brackets would have risen across the board, raising taxes not just for high-income earners but also for those with the lowest taxes as well. A host of other expiring provisions would have removed or lessened preferential treatment for certain investments, potentially leading investors to sell them off and thereby cause a drop in the stock market overall.
But in a compromise, lawmakers and the president agreed to extend the full suite of favorable tax provisions until the end of 2012. Here's a sample of some of the beneficial provisions:
- Long-term capital gains will continue to be taxed at a maximum 15% rate. Those who are in the 10% or 15% tax brackets pay nothing on capital gains.
- Qualified dividends also have a maximum tax rate of 15% applied to them. In general, if shares are listed on a U.S. exchange and you own them for more than 60 days surrounding the date of the dividend, then you'll qualify for the lower rate.
- Lower brackets across the board will keep taxes at a lower level. In addition, to replace the Making Work Pay tax credit that gave most taxpayers $400 or $800 in 2009 and 2010, a payroll tax holiday will drop the Social Security withholding rate by 2 percentage points, potentially saving each worker as much as $2,136 in payroll taxes this year.
As a result of these changes, investors will enjoy the status quo for another two years. So as you consider investing strategies to take advantage of these tax provisions, you may be able to use some of the tried-and-true techniques you've already been using.
Looking for dividends
Obviously, in order to take maximum advantage of favorable tax provisions, you want to earn the highest capital gains and dividends you can. Capital gains are impossible to predict, but finding dividend-paying stocks has never been easier.
You might think that picking the highest-yielding stocks would be the right move. But many of the stocks with the biggest dividends right now don't meet the requirements for qualified dividends. In particular, shareholders of real estate investment trusts Chimera Investment (NYSE: CIM ) and American Capital Agency (Nasdaq: AGNC ) have to pay their regular income tax rate on the dividends they receive.
But even if you take the absolute highest yields off the table, you still have plenty of high-dividend choices that do qualify for favored treatment. Here are six for your consideration:
Potential Annual Tax Savings on $10,000 Investment
|Altria Group (NYSE: MO )||6.2%||$124|
|Windstream (Nasdaq: WIN )||7.4%||$148|
|FirstEnergy (NYSE: FE )||5.8%||$116|
|CenturyLink (NYSE: CTL )||6.5%||$130|
|Duke Energy (NYSE: DUK )||5.5%||$110|
Source: Yahoo! Finance. Tax savings based on taxpayer in 35% tax bracket.
Whenever you're contemplating a stock, tax considerations should never be the only basis for your decision. Just because a stock pays a dividend that qualifies for lower tax rates doesn't mean that it's automatically a winning investment.
In fact, most of these companies face some significant challenges. FirstEnergy, for instance, has seen its stock drop substantially as utilities have generally underperformed the overall market. Lilly desperately needs its drug pipeline to pay off with some blockbuster drugs to replace those that are going off-patent soon. And according to some analysts, rural telecoms Windstream and CenturyLink are doomed to obsolescence, with virtually nonexistent growth prospects.
But for those willing to take those risks, the lower tax rates on their dividends are an added bonus. As long as dividend stocks enjoy lower taxes, they'll almost certainly stay in the forefront of investors' minds for the next two years and beyond.
The less taxing way to invest
What will happen to taxes beyond 2012 remains uncertain, especially with a new Congress potentially signaling an about-face in fiscal policy. What is certain, though, is that by taking advantage of tax breaks while they're available, you'll be able to keep more money in your pocket.
For more great dividend ideas, be sure to check out this free report on dividend stocks. Our Motley Fool analysts have identified 13 dividend-paying stocks that are good long-term plays. To download for free now, just click here.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.