The approach of the "fiscal cliff," the expiration of a host of tax and spending provisions, has broad implications for virtually every American as chronicled in last week's front-page story in the Chattanooga Times Free Press.
In particular, investors should be aware of a couple of significant tax provisions due to take effect (or more correctly to expire) on New Year's Day, and should consider taking action now to mitigate the potential impact to their portfolios.
As of Jan. 1, most of the tax cuts enacted in 2001 and 2003 are scheduled to sunset, allowing tax rates to revert to their previous levels. Although there are numerous facets to the fiscal cliff, investors are particularly affected by the reversion of the rates on dividend income and long-term capital gains. Going up, in case you were wondering.
The history of taxation on dividend income is tortuous, but a reasonable compromise was established in 2003 when the tax rate on qualified dividends was reduced to 15 percent.
Prior to the 2003 cut, dividends were treated as ordinary income and taxed at the top marginal rate to which a taxpayer was subject. This rate was particularly onerous since dividends are distributions of corporate earnings that already have been taxed at the company level and that are not deductible as corporate expenses.
The scheduled changes mean that taxes on dividend income for a couple filing jointly with an adjusted gross income of $70,000 will jump from 15 percent to at least 25 percent and perhaps 28 percent. Filers in the highest income bracket are slated to pay 43.4 percent, including a new 3.8 percent surcharge to help fund implementation of the Affordable Care Act.
In anticipation of the additional wallop to shareholders, some public and many private companies are contemplating the acceleration of January dividend payouts into December to beat the tax clock, at least for this quarter's distribution.
While it is unlikely that Congress will allow such a sharp increase to occur, high-dividend stocks would likely experience some selling pressure if a compromise fails to emerge.
Perhaps more significantly, capital gains taxes also are scheduled to increase in January, with rates increasing from 15 percent to 20 percent for most taxpayers holding a stock for at least one year. However, the best hope of a grand bargain on debt reduction centers around a proposal to reduce ordinary income tax rates but also to increase capital gains to 25 percent. Any plan with a reasonable chance of adoption would almost certainly include some variation on this theme.
Given this scenario, a reassessment of conventional wisdom is appropriate.
In particular, investors who have accumulated large concentrated positions and are traditionally averse to realizing tax gains should reconsider, given the likelihood that the tax bill next year will be worse, and possibly much worse.
No one ever went broke by taking profits, as the saying goes. And remember that taking no action is also a decision, one that might result in a larger contribution next year to Uncle Sam.
Christopher A. Hopkins, CFA, is a vice president at Barnett & Co.