After nearly a decade of easing taxes, it finally looks like investors can expect to see that trend reverse in the near future. But if you plan ahead, you can avoid some of the fallout that will ensue -- and not only save yourself taxes, but prevent losses on your investments as well.
Back in 2000, tax rates were substantially higher for most Americans. Tax brackets started at 15% rather than the current 10%, proceeded to 28% instead of 25%, and rose to nearly 40% as opposed to today's top 35% rate. A top rate of 20% applied to capital gains, and dividends were taxed at the same higher rate as investment interest and most other types of income.
Now, though, higher taxes look like a virtual certainty. The current 15% capital gains and dividend rates will likely go back to at least 20%, and the 39.6% tax rate on high-income taxpayers looks likely to return as well. Those changes will have an impact not just on your tax bill but also the attractiveness of your investments -- so you'll want to act long before any changes take effect. Specifically, here are three things to keep in mind:
The fall of dividends
Back in the early 2000s, dividends had virtually disappeared from the investing landscape. Companies favored stock buybacks and other ways to return capital to shareholders that made more sense from a tax standpoint.
But with more favorable tax rates, dividends came back into vogue. Following several accounting scandals, investors preferred the certainty of money in hand versus the somewhat manipulative nature of buybacks.
If tax rates rise, though, you can expect to see dividends hit with another setback. High-yielding stocks like Johnson & Johnson
Use your tax shelters now
High tax rates have always encouraged taxpayers to use any method available to avoid paying tax. To get a jump on the competition, you should look to take maximum advantage of tax deferral today, through IRAs, employer-sponsored 401(k) plans, and other tax-favored investments. As rates rise, the value of deferring or avoiding tax grows.
In particular, locking in low rates with a Roth IRA may prove the smartest move. Loading up your Roth with the stocks you see as having the most potential -- big-growth prospects that resemble what Apple
Bidding up tax efficiency
Stock investing gives shareholders a lot of control over timing their tax liability. Low tax rates make it less onerous to use short-term investing strategies.
In contrast, though, high tax rates make buy-and-hold investing more attractive. So you can expect the most solid companies -- stocks such as 3M
Similarly, for fund investors, one downside of actively managed mutual funds is their tendency to create a tax burden -- sometimes even during losing years. If tax rates rise, fund investors may want to reconsider passive options like index funds or ETFs to cut their tax bills. Passive investing generally incurs less tax, and gives the investor more control in deciding when to pay the piper.
No one likes paying higher taxes, but when you know they're coming, you can take steps to avoid the worst of it. By making these moves sooner than later, you can get a jump on other investors and hopefully put yourself in the best position to weather higher tax rates in the future.
For more on getting the most from your investing, read:
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Fool contributor Dan Caplinger is always ready for higher taxes. He owns shares of Philip Morris International. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor recommendations. 3M is a Motley Fool Inside Value pick. Apple is a Motley Fool Stock Advisor selection. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never disappoints.