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Get Ready for Higher Taxes

Watch out, investors. The campaign trail is taking aim at your wallet.

Aspiring presidential candidates have begun releasing their tax plans. As you would expect, both parties support tax policy that appeals to their traditional constituencies. Republican candidates want to see the tax cuts enacted in 2001 and 2003 made permanent. Several Democrats, on the other hand, are looking for ways to increase taxes, especially on high-income taxpayers.

Higher income tax rates
Those tax-hike proposals focus squarely on investment income. John Edwards, for example, released his tax plan earlier this week. It calls for raising the top tax rate on long-term capital gains from 15% to 28%, as well as repealing favorable tax rates on all types of income for those earning more than $200,000. Consistent with its intention to support low-income families, the plan also includes a small tax exemption on the first $250 of investment income to encourage those of modest means to start saving and investing.

Other candidates have taken a less aggressive approach toward existing tax provisions. Lower tax rates on dividends, capital gains, and ordinary income are all set to expire at the end of 2010. It's likely that some politicians may find it more expedient simply to wait for the cuts to lapse rather than pushing for an earlier repeal.

Hurting investors
Whether you support higher taxes in general, there's particularly bad news for investors in the specific methods tax hike proponents are recommending. While the tax cuts reduced the top rates on wages and other ordinary income by less than 5%, they cut the top rate on qualified stock dividends by a much larger amount -- from 38.1% to 15%. As a result, investors could see taxes on dividends double if the current tax cuts lapse. In addition, rates on long-term capital gains would increase from 15% to 20%.

It's unclear what effect higher tax rates would have on the broad economy and on investing behavior specifically. On one hand, many argue that lower tax rates unequivocally increase investment and promote economic growth. Yet some economists, such as Professor Greg Mankiw -- the former head of the Council of Economic Advisors -- believe that some types of cuts have different effects than others. Specifically, Professor Mankiw points to a Treasury report that argues that tax cuts on investment income and capital gains are responsible for a large percentage of resulting growth, even though they represent only a small portion of the revenue lost from passing the full tax-cut package.

Avoiding dividends
One thing is clear, though: A huge hike on tax rates for dividends will force many investors to reconsider owning high-dividend stocks. Lower taxes on dividends give those stocks an advantage over bonds, which some say is responsible for higher dividend payouts by companies.

For instance, many utility stocks -- long seen as a conservative sector that provides reliable dividend income -- have raised dividends since the tax cuts took effect, including Exelon (NYSE: EXC  ) , TXU (NYSE: TXU  ) , MDU Resources (NYSE: MDU  ) , and Centerpoint Energy (NYSE: CNP  ) . With higher taxes, those stocks will become less attractive, and companies may respond by diverting money away from dividends toward other methods of improving shareholder value, such as share buybacks.

Keep your eyes open
You probably don't need to worry about higher taxes before the 2008 election. But one thing you should consider is whether you're getting the full benefit of the low rates that currently apply. For instance, if it looks like taxes will go up in 2009, you may want to take some capital gains while lower rates are still in effect. Even though you'll pay current tax, you'll pay a lot less than you would if capital gains taxes rise to 28%. Similarly, make sure your tax-favored accounts are working for you. Higher taxes on dividends will make holding stocks in an IRA or other retirement plan even more attractive.

Taxes are just one component of successful investing. But it's important to save where you can. By staying aware of higher taxes in the future, you'll be able to take steps now to save as much as you can.

Related articles:

For more information on taxes, check out our Tax Center.

You can learn more about how taxes affect your retirement savings in our Rule Your Retirement newsletter. You'll find guidance on proper asset allocation, investment strategies, and how to take advantage of tax-favored accounts to put more money in your pocket. Take a free look for 30 days and see how Rule Your Retirement can help you successfully plan for your retirement.

Fool contributor Dan Caplinger does what he can to lower his taxes. He doesn't own shares of the companies discussed in this article. The Fool's disclosure policy will help keep your portfolio healthy.

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