Dividend Stocks Are Hot, But Beware Looming Tax Hikes

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[dropcap]D[/dropcap]ividend-paying stocks have snuck back into the investing spotlight recently. Many blue chip stocks have current dividend yields higher than their corporate bonds. And plenty of dividend payers are the sort of large caps that do best in a slow-growth economy, compared to small caps that excel in the early stages of a recovery or amid a strong growth backdrop. Think Coca-Cola (KO) or Procter & Gamble (PG).

But there are some looming tax issues that impact dividend stocks that you should take into consideration before loading up. Right now, qualified dividend income is taxed at a top rate of 15 percent. But that nice rate expires at the end of 2012, and we are scheduled to revert to the old system that taxes dividend income at your ordinary income tax rate. Right now that’s as high as 35 percent.

Of course, Congress can step in and pass a new law for 2013. But that isn’t likely to happen until at least after the November election, and what happens to the dividend tax rate will no doubt get tied up in some massive political wrangling. It might stay at 15 percent. And it might not. For what it’s worth (given the unknowability of the political landscape after the election), President Obama has repeatedly put forth a plan to raise the rate to 20 percent. Granted, that’s still better than taxing as income, but it would be a hike nonetheless.

A hike for high earners

And there’s one tax hike already on the books that will hit dividend income come 2013 for high-earners. As part of the health reform, if your adjusted gross income is at least $200,000 ($250,000 for married couples filing a joint tax return) and you have investment income, you will be susceptible to a new 3.8 percent Medicare investment surtax beginning in 2013. The tax will be levied on the lesser of your total investment income for the year, or the amount by which your modified adjusted gross income exceeds the $200,000/$250,000 threshold. (Investment income is added to wages to arrive at MAGI.)

Investment income includes all capital gains and dividend income that’s not tucked inside a retirement account. If you’re investing in ETFs or individual stocks you don’t have to worry about capital gains until you sell. But ongoing dividend payouts are another matter. At a minimum, if you’re eyeing dividend stocks these days, and you anticipate you will be in the crosshairs of the new Medicare investment surtax, you should consider stashing those dividend payers in tax-deferred retirement accounts.

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Carla Fried

Carla Fried is a freelance journalist who has covered just about every nook and cranny of personal finance for media including Money Magazine, The New York Times, and CBS MoneyWatch.com. Prior to launching her own reporting and writing business in 2002 she was a senior writer at Money and the managing editor of Quicken.com.

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