Favorable Dividend and Capital Gains Tax Rates Extended — for Now

Congress gave investors a break when it passed the 2010 Tax Relief Act. The act extended the 15% maximum tax rates on qualifying dividends and long-term capital gains for two more years. But like many congressional actions, it’s another temporary measure that is scheduled to expire on December 31, 2012. In 2013, unless lawmakers act, the favorable tax rates will return to their pre-2003 levels, and that’s the same year when higher-income taxpayers may be subject to a Medicare unearned income tax on net investment income to help pay for health-care reform.

Some investors may be tempted to sell stock and other investments to take advantage of the lower tax rates. Of course, taxes should not be the only consideration when deciding whether to sell an investment, but they can be an important part of the equation. Investors should also consider how an investment fits their time horizon, risk tolerance, and goals for growth and/or income.

Capital Gains: The Long and Short of It

Typically, you pay capital gains tax when you sell an investment, not while you own it. Tax rates depend not only on the holding period of the asset but also on your income tax bracket.

Long-term capital gains are profits from investments held longer than 12 months. Currently, investors in the 10% and 15% income tax brackets pay 0% in capital gains tax, whereas higher-bracket investors pay 15%. In 2013, these tax rates are scheduled to rise to 20% (10% for taxpayers in the 15% income tax bracket; 23.8% for the highest two tax brackets).

Short-term capital gains are profits from investments held for 12 months or less. They are taxed as ordinary income, which is not scheduled to change.

Dividends: The Qualified Kind

Dividend-paying stocks have historically been a way for investors to hedge against inflation. Taxes on qualified dividends are currently 15%, but they could reach 39.6% — that’s a 164% increase — if they revert to ordinary income tax rates in 2013, as they are scheduled to do. Because retirees often rely on dividends to supplement their retirement income, higher dividend taxes could hit them particularly hard.

Selling an investment before tax rates move higher may be a strategy to consider if the investment no longer meets your needs and tax situation. Fortunately, there’s plenty of time to reevaluate your mix of investments before higher tax rates return. Before you take any specific action, be sure to consult with your tax professional.

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