A Taxing Dilemma

You know in your heart that tax rates are going to rise. In fact you plan on it. You advise clients so and in your personal accounts you are positioned that way. They HAVE to, right? How else to fund the massive bailouts and stimulus programs.

But in the past, unlike this year, the IRS gave you some inkling by now of what it intended for the next year. Congress too. But they haven't and that is causing some stress among financial advisers.

As an example. advisers have been waiting to see what the tax rates on dividends will be for next year. This conundrum, and what investors want to know, were examined in a recent Wall Street Journal article:

Next year, what will the top tax rate on dividends be?

Investors like Clint Myers, an investment actuary in Georgetown, S.C., want to know. Some experts cite a 20% figure, while others say 39.6%, and still others talk about a tripling of the current 15% rate. "Lately I have seen figures citing almost any rate you can imagine," Mr. Myers says.

The short answer is that the 2011 nominal rate on dividends could be either 20% or 39.6%. Or something else—it is impossible to say given the legislative mood these days.

This is a big issue. Dividends provide approximately 40% of the total return to investors. How you tax them directly affects the allocations an adviser suggests for his/her clients. When will Congress act? We simply don't know but the present structure expires soon.

Next Jan. 1, a package of tax changes enacted under President George W. Bush expires. These provisions contained a historic change for dividends: For the first time, most were taxed at the same low rate as capital gains. Until then dividends had been grouped with interest, with both taxed at the higher rates levied on wages. In 2003 the nominal top rate on qualified dividends (usually, on stocks held longer than two months) dropped to 15%, where it has been ever since.

If Congress doesn't act, this reclassification will lapse at the end of 2010, and next year the top dividend rate would automatically revert to 39.6%.

The upshot is that next year the after-tax value of a 4% dividend yield on $100,000 of stock could be anything from $3,400 to less than $2,500 (before state taxes), and higher tax rates could lower the value of the underlying holding. Hardest hit, says Robert Gordon of Twenty-First Securities, could be utility stocks and fixed-rate preferreds with no way to adjust upward. He suggests a portfolio review to check for vulnerable spots.

Good advice.