Luke, an associate of mine, inspired this week's Smarter Investor column when he came into my office and posed a good question: "Are dividend-stock investors prepared for what's coming next year?"
What Luke is astutely referring to is the quite inevitable tax increase on dividend income in January 2013 when the Bush-era tax cuts are scheduled to expire. Currently, qualified dividends are taxed at an ultra-low 15 percent. But that can all change. In effect, the distinctions between qualified and ordinary dividends would disappear, making all dividends subject to ordinary income tax rates.
You've read that right: Dividends will be taxed as ordinary income, so if you're married and filling jointly and you earn a combined income above $43,850, then you will pay 28 percent on your dividend income. That's almost twice as much in dividend income tax as you paid the previous year! To make this dreadful situation even more painful, you must also account for the 3.8 percent Obamacare surtax on "high income earners." With this additional tax taken into account, the top tax rate on dividend income will go from 15 percent to 39.6 percent, a tax increase of 264 percent!
I believe this massive tax increase will affect those who count on dividend income the most for everyday living expenses: millions and millions of retirees. Lets say a retired couple has $600,000 in dividend-paying stocks yielding about 4 percent, or $24,000. In 2012, they would have to give back $3,600 of their $24,000 in dividend income taxes, netting them $20,400. Fast-forward to 2013 and that same retired couple moves from a 15 percent bracket to 28 percent; now they will have to give back $6,720 of their $24,000 in dividend income taxes, netting them $17,280.
Understand that nothing changed in their investment strategy, but they are forced to give more to the government and keep less of their hard-earned money.
This is a tough scenario for investors that have loaded up on dividend-paying stocks during the last few years seeking a better risk-adjusted return than CDs or money markets. I imagine that the best, proactive advisers are having this very conversation with their clients.
A couple straightforward options exist that smart investors and advisers should consider in order to maintain their current income streams:
1) Selectively invest in higher-yielding investments so the net income (after taxes) is equivalent to your current income.
2) Complement your income plan with income tax-free or tax-favored investments.
3) Carve out a portion of your portfolio and create an income ladder with CDs or fixed/hybrid annuities to create a guaranteed income stream.
Robert Russell is CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to FOX Business and CNBC.
Securities offered through Kalos Capital, Inc., Member FINRA, SIPC. Investment Advisory Services offered through Kalos Management, Inc., 3780 Mansell Rd. Suite 150, Alpharetta, GA 30022, (678) 356-1100. Russell & Company is not an affiliate or subsidiary of Kalos Capital, Inc. or Kalos Management, Inc.
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