At 72, Paul Nagorski likes to own stocks that come with their own payday. Dividend checks add to his income.
The Kansas City, Mo., resident soon may be sharing more of his investing income with Uncle Sam. Like other investors, he’s heading for a tax cliff on Jan. 1.
“I’ll pay more,” Nagorski said. “I can afford to do it. I don’t like to do it.”
Now that the election is over, attention has turned to how President Barack Obama and Congress intend to deal with the automatic tax increases and spending changes set to kick in on New Year’s Day. Lawmakers had set up this fiscal cliff to force themselves to negotiate a long-term reduction in the federal deficit.
Failure to reach a deal would mean a sudden drop in federal spending, an end to the Bush-era tax cuts and other tax changes on Jan. 1.
Dividends, stock gains, estates and even ordinary income would be taxed at higher rates — with the impact being felt broadly in the investing world.
Even investors inside tax-deferred accounts such as 401(k) plans and individual retirement accounts could feel the lingering changes wrought by the tax side of the fiscal cliff. This automatic rewriting of tax rules stands to make many investment choices less attractive, and a few more valuable.
The traditional year-end advice from tax experts has turned topsy-turvy. The standard advice, to sell losers to offset profits and reduce taxes, is morphing into recommendations of selling winners to take advantage of lower capital gains rates that are set to rise in 2013.
Some companies flush with cash are cutting special dividend checks to shareholders before the year ends. Those dividend benefits may be harder to come by next year if tax rates climb and companies decide to pay out smaller rewards.
If bracing for the tax cliff seems complicated, January’s changes are only half of it. Washington may call off all, some or none of the scheduled tax changes.
“It’s all up in the air,” said Rich Romey, president of ETF Portfolio Partners Inc. in Leawood, Kan.
Lawmakers are under great pressure to stop the fiscal cliff from happening.
Economists warn that the combination of $400 billion in higher tax bills — including the end of the payroll tax cut and extension of the Alternative Minimum Tax to 30 million Americans — and $200 billion in federal spending cuts could send the slowly recovering economy back into a recession.
And a recession won’t help anyone’s investments.
All stocks affected
Investors may not know it, but they’ve been enjoying a decade-long tax break.
Thanks to Bush-era tax changes, most investors pay a 15 percent tax rate on stock dividends and capital gains.
But the breaks expire in seven weeks and older, higher rates kick in, barring 11th-hour compromises. Investors with larger incomes also would see a new tax on their dividends and higher capital gains rates starting Jan. 1.
Expect stock prices to suffer.
“The tax side of the fiscal cliff is onerous to all stocks,” said Mark Eveans, chief investment officer at Meritage Portfolio Management Inc. in Overland Park, Kan.
One simple reason is that higher taxes mean investors will keep less of the rewards. If owning a stock is less rewarding, investors won’t be willing to pay as much.
The tax on capital gains would climb to 20 percent after the fiscal cliff.
Stock dividends would be hit even harder in the 2013 tax world.
Instead of owing 15 percent, investors who collect dividend checks would be taxed at their regular individual income tax rates. And those rates would go up Jan. 1 as other parts of the Bush-era tax deal expire.
For many investors, Uncle Sam’s dividend bite would jump to 28 percent or higher as some tax brackets disappear and the higher tax brackets begin to apply at lower income levels.
For example, the 15 percent income tax bracket currently extends to $70,700 of income for a couple filing jointly, according to H&R Block. Come Jan. 1, it applies up to only $58,200 in income. And the 25 percent bracket disappears, setting 28 percent as the next bracket, according to Block.
The highest tax bracket climbs from 35 percent to 39.6 percent in the New Year.
But the tax cliff doesn’t stop there. Individuals with incomes of $200,000 or more, or couples earning $250,000 or more, would start to pay a 3.8 percent additional Medicare surtax on their investment income, including dividends.
Combined, it means higher-income investors would see their dividend tax rate jump from the current 15 percent rate to 43.4 percent.
Investors inside tax-deferred IRAs and 401(k) accounts shouldn’t feel immune to the tax cliff.
Dividend stocks have become increasingly popular as interest rates on bonds have plunged to historic lows. The lower tax rate on dividends has added to their investor appeal, as interest income doesn’t qualify for the special 15 percent tax rate.
The upshot is that many investors may decide highly taxed dividends aren’t for them and sell those stocks, which could hurt the stocks’ prices. More may prefer municipal bonds that don’t trigger a federal tax bill.
“Even if you do nothing because of this, other investors will do things,” Romey said.
Corporate dividend plans already are shifting to accommodate the approaching tax cliff.
Commerce Bancshares Inc., which operates in five states, last week announced a $1.50 a share special dividend to be paid Dec. 17. It means Commerce’s stockholders can still claim the 15 percent dividend tax rate that is set to be wiped out by the tax cliff.
Jeff Aberdeen, the bank’s controller, said it’s the first special dividend in his memory.
“You try and make money and keep a safe bank, but also you try to figure out how to give the best returns to shareholders,” Aberdeen said.
After the tax cliff, dividends would be less valuable to many investors, and companies would recognize the changing math.
Eveans said that means dividend increases, which can be a big boost for shareholders, may be less common after the tax cliff.
Corporate finance executives may see other uses for that money as more valuable, perhaps buying back more of the company’s own shares. The idea is the buyback will support stock prices and help investors collect gains when they sell. And a gain taxed at 20 percent could be more valuable than a dividend taxed at 28 percent or higher.
Tax experts have had to alter some of their typical year-end tips for investors because of the tax cliff.
Traditionally, they suggest selling some losing stocks late in the year. The losses can offset other income and lower their overall tax bill.
“People have always tried to harvest losses. Now it doesn’t make sense,” said Scott Slabotsky, lead managing director of CBIZ MHM LLC in Leawood, Kan.
The new advice: Consider saving some stock losses to take next year when they would protect income from higher tax rates that could kick in Jan. 1.
The tax cliff also means it makes sense to consider selling winning stocks before the New Year.
All this advice comes with a big caution. Don’t make any investment decisions solely because of taxes.
Jan. 1 also may bring changes to estate taxes and gift taxes, influencing the advice from estate planners.
The 2012 tax rules exempt $5.2 million from the 35 percent estate tax. Next year, the exemption falls to $1 million and the rate jumps to 55 percent.
During a September conference call with clients, a Commerce Trust Co. planner suggested clients “think big” in terms of gifts this year before scheduled tax changes next year make them more difficult to do.
Small gifts to charities and other regular charitable deductions, however, would be more valuable next year when income tax rates are higher.
That is, unless Washington steps in to address the fiscal cliff before it happens.
Lawmakers may simply extend the current tax rules for six months to give them more time to address the long-term problems that led to the crisis in the first place. But the same questions about raising taxes and cutting spending will come back up.
“They can’t kick the can down the road forever,” said Dave Anderson, a portfolio manager at Financial Counselors Inc. in Kansas City.