By Mark Miller
CHICAGO Aug 17 Washington's fiscal cliff offers
a tax hike for just about everyone to hate. If Democrats and
Republicans can't strike a deal on an extension of the Bush-era
tax cuts by the end of the year, tax rates on income, capital
gains, dividends and estates all will jump.
A dividend tax hike could hurt some seniors, who report a
substantial amount of dividend income on their tax returns. But
for most seniors, there actually would be very little impact if
rates do jump. Let's take a look at the numbers:
The Bush-era tax cuts, set to expire at the end of this
year, reduced the maximum tax on qualified dividends and capital
gains to 15 percent - and to zero for filers in the 10 percent
and 15 percent tax brackets.
But if the cuts expire at year-end, the maximum rate on
capital gains will be 20 percent; dividends would go back to
being taxed as ordinary income, at Clinton-era rates. Filers in
the highest bracket - 39.6 percent - would see a substantial
jump in taxes on dividends; so would filers in the lowest
brackets, whose rates would go from zero to 10 percent, or 15
Whether any of this comes to pass depends very much on the
outcome of the November election.
"If the Democrats do well in the election, you could see a
compromise solution in the lame-duck session," says Mark
Luscombe, principal federal tax analyst at CCH. "If the
Republicans take full control of Congress and the White House,
they may decide to wait until next year to enact what they
A study of Internal Revenue Service filing data by the
Edison Electric Institute makes the case that seniors would take
the hardest fall off the cliff where dividends are concerned.
Thirty-two percent of all tax returns reporting qualified
dividends were filed by taxpayers age 65 and older; 68 percent
were from returns with incomes less than $100,000, and 40
percent were from returns with incomes less than $50,000.
Other evidence suggests the damage among seniors would be
About 79 percent of senior filers had incomes under $75,000
last year, and this group reported just 5.5 percent of all
capital gains and dividend income last year, according to a
study by the Tax Policy Center, a joint venture of the Urban
Institute and Brookings Institution.
Most reported dividend income was concentrated among high
income households with incomes over $100,000 - just 13 percent
of all over-65 filers.
So, what would happen if the preferential tax treatment for
dividends and capital gains were eliminated? For the majority of
seniors (60 percent), after-tax income would fall by less than
one-tenth of one percent, on average.
Wealthier seniors would take a bigger hit. For example,
filers with income from $500,000 to $1 million - a really small
group - would see after-tax income fall 3 percent.
Wealthy elders would pay not only the higher tax rates on
dividends, but also the new 3.8 percent Medicare contribution
tax on net investment income (interest, dividends, capital gains
and rents) enacted to help pay for the Affordable Care Act. That
tax affects individuals with modified adjusted gross income over
$200,000, and married joint filers with MAGI over $250,000.
HOW TO PROTECT YIELD
For wealthy investors looking to protect investment income,
the political uncertainty makes it difficult to take proactive
One option would be to accelerate capital gains into this
year. "Even if you wanted to keep a stock, you could sell it now
and re-purchase it, since the wash-sale rule applies only to
loss situations," says Luscombe. "But if the Republicans take
control and reduce the rates beyond what we have now, you could
look fairly foolish," he cautions.
Converting tax-sheltered IRA assets to a Roth IRA this year
offers an effective insurance policy against the risk of higher
tax rates next year or down the road, Luscombe notes. You'd owe
income taxes on whatever amounts are converted this year at the
current Bush-era rates, but the assets - along with any
appreciation - would come out of the Roth tax-free in the future
for you or your heirs.
Also, you'd have the opportunity to "re-characterize" the
converted funds anytime until October 15th next year - meaning
you could change your mind and reverse the conversion. You might
want to do that if a tax deal to your liking materializes before
then, or the value of your holdings falls after the conversion -
leaving you with an income tax bill on evaporated holdings.
"If you made money, you keep the Roth," says IRA expert Ed
Slott. "If not, you can reverse it, eliminating any taxes on
value that no longer exists."
MAXIMIZE AFTER-TAX RETURNS
No matter what happens in Washington, investors should think
strategically about asset location - maximizing after-tax
returns by buying and holding stocks or bonds in either taxable
or tax-deferred accounts, urges Maria Bruno, a senior investment
analyst in Vanguard Investment's counseling and research group.
Vanguard suggests buying tax-efficient broad-market index
equity funds or exchange-traded funds in taxable accounts; hold
bonds, bond funds or dividend-oriented funds or shares in
"You want to have different buckets of taxable and
tax-advantaged accounts, and focus assets that are inefficient
from a tax perspective in the tax-sheltered accounts," Bruno
There could be a buying opportunity for high-yield equities
if the tax rates do jump next year, says Josh Peters, editor of
Morningstar's DividendInvestor newsletter.
"If high net worth investors dump dividend stocks for tax
reasons, it could be a good opportunity for investors in lower
brackets who aren't affected by the tax changes to add to their
holdings at lower valuations and higher yields," says Peters.