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What to Do If Washington Takes Your Retirement Dividends Away

Your next strategy depends on your tolerance for risk


While all eyes are on the tight election race between President Barack Obama and Mitt Romney, income-seeking investors had better focus on tax strategies heading into 2013.

There are major worries as the tax cuts signed into law by President George W. Bush are set to expire at the end of this year, considering that control of the two houses in Congress is split. Obama has expressed a desire to extend the tax cuts again — except for individuals earning more than $200,000 a year and couples filing jointly who earn more than $250,000.

Cash in on Boomers with Senior REITs
Cash in on Boomers with Senior REITs

For investors, an obvious concern is that their top margin tax rates will increase in 2013. Taxpayers whose current marginal rates are 25%, 28% or 33% will see their top rates increase by 3%.

Taxpayers currently in the 35% bracket — for 2012 earning $388,351 or more, filing jointly — will see their top marginal rate increase to 39.6%.

For joint-filers earning more than $250,000 ($200,000 for individual filers and $125,000 for married couples who file separately), there will be an additional 3.8% Medicare tax beginning in 2013 to pay for the Patient Protection and Affordable Care Act of 2010, also known as “Obamacare,” for the lesser of earnings above the threshold, or investment income.

Taxes on qualified dividend income currently is capped at 15%, but that will expire at the end of 2012 without action from Congress and the president. This means the expiration of the Bush tax cuts can have a huge effect — even on filers who aren’t in one of the higher tax brackets.

Under the current cap on dividend taxes, if an investor’s adjusted gross income — again, married, filing jointly — is below the $70,701 threshold for the 25% tax bracket, the investor is paying no taxes at all on qualified dividends, which include most income from corporate bonds and preferred stock. For higher-income investors, the top “all-in” rate paid on taxable dividend income, including the new Medicare tax, can be as high as 43.4%.

Many readers can rightly point out that nobody pays the top rate because of the various income deductions and tax loopholes that exist. But it is a graduated rate, and a portion of the investor’s income might well be taxed at or near their highest graduated rate. Therefore, the highest rate can be used for comparing taxable and tax-exempt income investments.

With municipal bond rates being so low for so long, and with the 15% cap on taxes on qualified dividends, many investors have avoided municipal bonds for years. In the low-rate environment, some yield-hungry investors have decided to take additional risk by focusing on preferred shares or trust preferred shares for income.

So the main factor in deciding between taxable or tax-free income paper — if the tax on dividends is reinstated — is your tolerance for risk.

Taxable or Tax-Free?

For investors who wish to stick with higher-rated bonds, here’s a quick comparison, illustrating tax implications, the dismal overall rate environment and the market pressure on municipal bond prices. (Note: These are not investment recommendations, just food for thought.)

A newly issued New York Triborough Bridge and Tunnel Authority bond that settles on Thursday and matures on Nov. 15, 2023, has a coupon of 5%, with a yield of 2.26%, through its optional redemption date of Nov. 15, 2022. The bond is rated Aa3 by Moody’s Investors Service and AA- by Standard & Poor’s. While that might not seem to be a very impressive yield at first, the interest is exempt from federal, New York State and New York City income taxes.

In case you’re wondering why the yield is so low relative to the coupon, it is because many municipal bonds are issued with above-market coupons and huge premiums. If rates move up sharply and the market price of the bond declines below par — known as a “de minimus” situation — some investors are subject to federal income taxes on the otherwise tax-exempt dividend.

If you divide that 2.26% yield by one minus your combined marginal tax rate, you have the taxable equivalent yield, which can be used for comparison. Going to extremes, if you are in the highest federal tax bracket — with your investment income also subject to the new 3.8% Medicare tax for a combined 43.4% federal rate — your taxable equivalent yield on the Triborough Bridge and Tunnel Authority paper is 3.99%.

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