Dividends or Share Buybacks: A Taxing Dilemma MORNINGSTAR By Alex Bryan | Morningstar – Oct 18, 2012
While there's been a lot of talk about the looming "fiscal cliff," rarely does even a highly partisan political divide prevent politicians from cooperating at the last minute to find some sort of temporary solution. Sure, the resolution may neither be prudent nor long-term in scope, but most can logically predict that something will be done. With that said, regardless of how the cliff is resolved, we believe investors should care more about how we'll be paying for the spending that will be incurred. There is a good chance that tax hikes are right around the corner, and those will directly hit most investors' pocketbooks if enacted.
Tick, Tick, Tick ... If Congress does not take any action, starting on Jan. 1, the government will tax all dividends at ordinary income rates instead of the preferential 15% treatment for qualified payouts. On top of that, as part of the Health Care and Recognition Act of 2010, investors whose income exceeds $200,000 or $250,000 for single and joint filers, respectively, will be subject to an additional 3.8% Medicare surtax on all dividends, interest income, and capital gains. This new tax will remain in effect even if Congress extends the Bush tax cuts.
As a result, the top dividend tax rate could increase to 43.4% from 15%. Taxes on long-term capital gains are also scheduled to rise for most investors to 20% from 15%. (This rate will decrease to 10% for investors in the 15% income tax bracket.) However, with the Medicare surtax, the top rate will increase to 23.8%.
While we can't predict the outcome of the election, there is a good chance that these tax hikes will remain in place for investors in the upper income tax brackets. The Medicare surtax almost certainly isn't going away. Rather than trying to determine whether the tax changes will take effect, a more relevant question may be how to be prepared if they do.