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Combat the Coming Dividend Tax Increase

How to Combat the Coming Dividend Tax Increase

This Tax Loophole Let’s You Ignore the Dividend Tax Completely

By Marc Lichtenfeld, Editor, Wealth Retirement

It’s clear that President Obama views his re-election as confirmation of his claim that the wealthiest Americans should pay more in taxes. And one of the quickest down and dirty ways will be to increase the tax on dividends.

Unfortunately, the dividend tax increase is going to affect nearly everyone… YOU included.

Soaking the Rich… and Drenching Everyone Else

Sure, Obama’s said that taxes will only go up for the top 1% – the filthy rich – the 2% or, at the least, those making $200,000 or more. But, with all due respect to the man and office, the President’s proposal to raise the tax on corporate dividends has the ability to affect anyone with an investment in dividend-paying stocks, from the top executive on Wall Street to the grandmother on Main Street.

You pay 15% on dividends right now. If the Bush tax cuts are allowed to expire, three bad things happen to investors: The top federal rate goes from 35% to 39.6%, the 15% rate on dividends and capital gains is over and a reduction of itemized deductions starts phasing in.

Bottom Line: Dividends will be taxed at the same level as wages and salaries in 2013. That means, no matter who you are, Uncle Sam is going to be digging a little bit deeper into your pockets. And higher dividend tax rates look likely even if both parties in both houses and the White House decide to extend the Bush tax cuts another few months.

You see, the corporate dividend tax hike is part of Obama’s broader restructuring of America’s corporate tax structure. As a whole, the plan is a game-changer for American business… and dividend investors.

Mr. Obama’s proposal to raise the dividend tax rate to match each individual’s personal income tax rate means that the richest Americans will see a dividend tax bracket of 39.6% in 2013, more than doubling their rate. But anybody paying more than 15% in taxes right now will see their dividend tax rate increase (and this is not counting state taxes).

Worse still, IRS data show that retirees and near-retirees who depend on dividend income would be hit especially hard. Almost three of four dividend payments go to those over the age of 55, and more than half go to those older than 65.

I get that if someone is wealthy and generates all of their considerable income from their investments, there needs to be a way to tax them. Fine, come up with a way.

But for the average investor who does everything right – works hard, saves and invests – it amounts to double taxation, which is wrong. So these investors need to find ways to hang on to more of what’s theirs.

Here are three steps you can take to keep more of your money and give less to Uncle Sam…

1.) Move your dividend-paying stocks into an IRA – If you’re able, this is one of the best things you can do, as your dividends will be paid tax-deferred. This is especially important if you’re reinvesting dividends, because when you reinvest dividends, you’re taxed on those dividends even though you never receive the cash (the dividends automatically buy more shares).

Holding your dividend reinvestment stocks in a taxable account could cause a fairly steep tax liability as your shares compound over the years. So, if possible, keep those stocks in an IRA.

2.) Look for stocks with low payout ratios – Historically, when dividend taxes have been raised, companies that are able will raise the dividend, so that shareholders’ income won’t be drastically reduced by the higher tax. Obviously, not all companies can or will do this. But one with a lower payout ratio is more likely to.

If a company has a 3.5% yield, for example, raises its dividend for 12 consecutive years and has a payout ratio of just 33%, that means it pays just a third of its net income to shareholders in the form of dividends. That gives it plenty of room to raise the dividend if management chooses.

And Our Personal Favorite: Avoid the Dividend Tax Increase Completely

3.) Consider MLPs – Master limited partnerships (MLPs) are stocks that are similar to REITs in that they must pay 90% of their net income in the form of dividends (called distributions). And like REITs, MLPs often have higher yields than typical dividend stocks.

However, there’s one key aspect of these cash distributions that makes them attractive from a tax perspective…

Because the investor is considered a partner and not a shareholder, the cash distribution is considered a return of the partner’s capital, not a dividend. That means it’s not taxed as a dividend.

Instead, it lowers the partner’s cost basis. This is important for two reasons. You collect the cash tax-deferred until you sell the shares, and the capital gain tax is likely to be lower than the new dividend tax.

Here’s how it works…

Let’s say you buy 100 shares of an MLP for $20 per share and receive a $1-per-share distribution, where all of it is considered a return of capital.

(The company will send tax documents that let you know how much is a return of capital.)

In the year you receive the $100 ($1 per share), you won’t pay taxes on the distribution. Instead, it lowers your cost basis to $19. Moving forward, over the next three years, you receive $1 per share in cash each year. After four years, you’ve collected $400 in cash and haven’t paid a penny to Uncle Sam.

But now, your cost basis is $16 ($20 – $4).

Let’s say you then sell the stock for $22. You’ll pay capital gains on $6 instead of $2 per share.

That’s because you bought it for $20, sold it for $22, and had your cost basis reduced by the $4 you received in cash.

So you still have to pay taxes on the money you receive. But you pay it later and you pay it when you decide. Even waiting until you retire if you so choose (thereby lowering your tax bracket considerably).

If you’re close to retirement, owning MLPs can be a terrific way of generating tax-deferred income while you’re working and presumably in a higher tax bracket. But the idea is to then take profits and pay taxes when you’re retired and in a lower tax bracket.

Admittedly, this explanation is very simplified, so be sure to speak with a tax advisor before investing in MLPs. Also, keep in mind that most MLPs are energy related, so while MLPs can be attractive from an income and tax perspective, you probably don’t want to pack your portfolio with too many stocks in one sector.

Nonetheless… it’s a worthwhile – and legal – way of keeping more of your money.

And with that in mind, there’s one particular MLP that really stands out among the competition…

A Global Enterprise with a World-Class Payout

Let me introduce you to a company that might be considered a pseudo-utility: the master limited partnership (MLP) Brookfield Infrastructure Partners (NYSE: BIP).

As the name might suggest, it runs numerous infrastructure-related businesses around the world, including:

  • 5,100 kilometers of railroad track in Western Australia
  • 30 port terminals across the United Kingdom and Europe
  • 15,500 kilometers of natural gas transmission lines mainly in the U.S.
  • 526 MWth district heating system and a 76,000 ton deep lake water cooling system in Canada
  • A main artery in Santiago Chile’s urban roadway
  • One of the world’s largest coal export terminals
  • 8,800 kilometers of transmission lines in North and South America
  • 1.5 million electricity and natural gas connections
  • 419,000 net acres of timberland in British Columbia, Canada

That’s a diverse set of businesses!

Better yet, because of this broad spectrum, significant portions of its cash flow are under contract or regulation. That pretty much ensures its dividend will be paid. Meanwhile, the remaining business allows variability for growth.

Of course, being a diverse global business is a huge bonus in and of itself. It helps spread out the company’s risk in case one country or region suffers a weak economy… an added bonus in these uncertain times.

Why This Dividend is Moving Higher… And Fast

Brookfield was created in 2008 as a spin-off from Brookfield Asset Management (NYSE: BAM), which still manages the MLP counterpart.

During those first two years, in 2008 and 2009, Brookfield Infrastructure Partners paid out quarterly distributions of $0.265. In 2010, it raised its dividend by a penny. Then it boosted the payout to $0.31 per share in the first quarter of 2011 and increased its dividend again that year to $0.35 per share.

As of December 2012, it’s $0.375.

But here’s the real kicker… The MLP’s stated goal is to pay out 60% to 70% of funds from operations (FFO). And since it’s only up to 65% so far, there’s still room for that dividend to grow a bit further, especially with the business as healthy as it is from a purely technical standpoint.

In its third quarter 2012, the company reported FFO of $113 million, a significant jump over the $97 million in third quarter 2011. That’s thanks to Brookfield’s transport and energy and utilities platforms, which grew despite the unsettling economic picture across Europe and the U.S. especially.

In other words, between its status as an MLP, its dividend pledges and its global presence, there almost certainly more to look forward to in the months and even years ahead.

Action to Take: Buy Brookfield Infrastructure Partners (NYSE: BIP) at the market. Set stop loss 25% below your entry price. As an MLP, it has different tax consequences from a regular stock. Be sure to speak with your tax professional if you have any questions about MLPs.