A Primer on the Upcoming Tax Hikes on High-Income Investments

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

Overall, it was a solid week for your Dividend Pro portfolio, with many of your positions rising 1% or more.

That said, the uncertainty surrounding the “fiscal cliff” and its implications, particularly for dividend stocks, has cast a pall on the entire income sector.

As it stands now, on December 31, 2012, all of the Bush-era tax cuts are set to expire, including the 15% tax rate on qualified dividends.

So this week, I wanted to give you a quick summary of how this affects your Dividend Pro portfolio. In doing so, I’m relying on analysis from Parsimony Investment Research.

Let me start with a reassuring conclusion:

Unless you earn a huge amount of income from qualified dividends, the situation isn’t as bad as it first appears. Dividend stocks will remain one of the best income-generating options for investors for the foreseeable future. And in any case, many of your best income-generating ideas in Dividend Pro will remain unaffected as they fall into unaffected categories.

1. “Qualified Dividends” from Dividend Stocks

The worst case scenario for dividend investors is that all Bush-era tax cuts expire (including the 15% tax on qualified dividends) as dividend income will be taxed as ordinary income.

For individuals earning $200,000 and couples earning $250,000, there also will be a new 3.8% tax rate that comes as part of the Affordable Care Act on certain types of income, including dividends, capital gains and rental income. With no action between now and then, the top tax rate on dividends will nearly triple to 43.4% — a combination of the highest marginal rate of 39.8% and the 3.8% Obamacare surcharge.

The table below highlights the estimated tax rates for 2013 under this scenario.

Say you fall into the 28% or 31% brackets. At first glance, it looks like your tax rate on dividends will essentially double. However, when you do the math, you will find that your effective tax rate will be much lower than your headline marginal rate.

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A retired married couple (filing jointly) with $80,000 of dividend income would have a marginal tax rate of 28%. However, their effective tax rate would be 18.2% (since the first $60,550 of dividend income would be taxed at 15%). In this example, the couple’s after-tax dividend income would decline by only 3.7% if the Bush-era tax cuts expire completely (see table below).

In your Dividend Pro portfolio, payments from Global X SuperDividend ETF (SDIV) and PowerShares Preferred (PGX) are “qualified dividends” as preferred stock exchange-traded funds (ETFs) are taxed as common stock dividends.

II. Development Corporations (“BDCs”), Master Limited Partnerships (“MLPs”), or Real Estate Investment Trusts (“REITs”)

Dividends paid by tax-exempt corporations or trusts, such as Business Development Corporations (“BDCs”), Master Limited Partnerships (“MLPs”), or Real Estate Investment Trusts (“REITs”) are considered non-qualified, and are typically taxed at ordinary rates.

Among your current Dividend Pro holdings:

Two Harbors Investment Corp. (TWO) and Annaly Capital Management (NLY) are REITs.

Apollo Investment (AINV) and Fifth Street Finance Corp. (FSC) are BDCs.

CVR Partners, LP (UAN)Rentech Nitrogen Partners, L.P. and Northern Tier Energy Trust LP (NTI) are MLPs.

These stocks or ETFs will NOT be affected by a dividend tax hike because non-qualified dividend income is already taxed at ordinary rates.

III. Dividend Stocks and ETFs Held in a Tax-Deferred Account (like IRAs)

If you hold your dividend stocks in a tax-deferred account (like an IRA), you will not be affected immediately by a dividend tax hike. Dividends are paid into your IRA account, and are tax-deferred and not currently taxable to you, unlike dividends in a regular taxable investment account.

When distributions are taken from an IRA account, they are immediately taxable at ordinary income rates. Even if a dividend paid into an account was originally a “qualified” dividend, when it is withdrawn from an IRA, that special tax status vanishes and it is taxed at ordinary income tax rates.

IV. Tax Free Investments

Municipal bonds and the ETFs that invest in them are unlikely to lose their tax-exempt status as part of the “fiscal cliff” negotiations.

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That’s why you’ve seen your Dividend Pro investment in this sector — PIMCO Municipal Income Fund II (PML) — do particularly well in recent weeks.

Bottom line

While a dividend tax hike is hardly welcome, the case for high-income dividend stocks remains strong. The Fed’s zero interest rate policy has essentially guaranteed that interest rates will remain near zero percent until at least 2015. Dividend stocks will remain one of the best income-generating options for investors for the foreseeable future.

Portfolio Update

Global X SuperDividend ETF (SDIV) rose 1.84% last week. Because international investors are not affected by changes in U.S. tax rates and dividend yields are still attractive in the current environment, there is unlikely to be a broad-based flight from global dividend-paying companies stemming from the U.S. fiscal cliff. Trading below its 50-day moving average (MA), SDIV is a HOLD.

Two Harbors Investment Corp. (TWO) rose another 1.35% this past week. Recent insider buying indicates the stock is undervalued. On Nov. 20, William Roth (an officer) purchased 10,000 shares at $11.08 per share in a transaction valued at $110,800. On Nov. 16, Steven Kuhn (an officer) purchased 20,000 shares at $10.82 per share, in a deal valued at $216,400. TWO remains a HOLD.

PIMCO Municipal Income Fund II (PML) rose 2.60%. PML extended its rally on expectations that the Bush tax will expire, making the tax-exempt status of munis that much more attractive. Look for your monthly payout on or around Dec. 8. PML remains a BUY.

Apollo Investment (AINV) rose 1.12%. With the implementation of the Dodd-Frank Bill, the Volker Rule, and/or Basel III, banks and hedge funds that once might have been competitors of AINV are becoming more risk averse. Yielding 9.8%, and trading above its 50-day MA, AINV is a BUY.

Omega Healthcare Investors Inc.(OHI) rose 1.07%. Since October 2002, Omega’s stock price has appreciated by 18.6% annually and the company’s 10-year total return has been over 653%. With the stock trading below its 50-day MA, OHI remains a HOLD.

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PowerShares Preferred (PGX) rose 0.41%. PGX pays a monthly dividend and now yields over 6.5% with very low volatility. PGX will pay out its monthly dividend in the middle of December. This monthly income payer is a HOLD.

Fifth Street Finance Corp. (FSC) rose 0.76%. Net investment income for the quarter ended September 30, 2012, was $22.3 million, or $0.27 per share, as compared to $20.0 million, or $0.28 per share, for the quarter ended September 30, 2011. A dividend of 9.58 cents per share is payable on Nov. 30 to stockholders of record on Nov. 15. The company has confirmed this monthly dividend through the end of February 28, 2013. FSC remains a HOLD.

CVR Partners, LP (UAN) recovered 1.28% this past week. As the recent drought raises crop prices, it makes producers more likely to boost spending for fertilizer in 2013. With UAN’s capacity to increase by 50% as a result of recent expansion projects, this stock has big upside. Still trading below its 50-day MA, UAN is a HOLD.

Rentech Nitrogen Partners, L.P. (RNF) rose 1.47%, and is now on the verge of breaking out to an all-time high. Yielding 8.80%, RNF remains a BUY.

Annaly Capital Management (NLY) rose 0.14%. NLY recently announced a deal to buy Crexus Investment Corp. (CXS), which was valued at $840 million. NLY remains a HOLD.

Peritus High Yield ETF (HYLD) dropped 0.5%. Actively managed by Peritus I Asset Management, the fund buys junk bonds that are trading below face value. This allows for potential price appreciation on top of the yield income. Still below its 50-day MA, HYLD is a HOLD.

Northern Tier Energy Trust LP (NTI) rose 0.72%. The company reported that a small leak was detected in one of its process units. There were no reported injuries and crude rates were not impacted. NTI remains a BUY.

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