Sales in the Sunset

With the federal deficit at record levels, it seems increasingly unlikely that Congress will extend the tax cuts enacted in 2003 by the Bush Administration that are set to expire at the end of 2010. The sunset of these provisions presents investors with a number of tough decisions.

The Bush tax cuts reduced the long-term capital gains rate to 15 percent, and also lowered the qualified dividend tax to 15 percent. Barring a sudden change of heart by Congress and the Obama Administration, long-term capital gains—securities held for longer than a year—will then be subject to a 20 percent tax. Dividend income would be taxed at the ordinary income levels, a change that could represent a significant tax increase for many investors.

The rollback on tax cuts would have an immediate impact on nearly all investors. But those with low-basis stock—namely, stock that has appreciated considerably—and those whose income depends on their dividends would have the most to think about.

Dump the Dividends?

If you are holding a large amount of low-basis stock that you’ve considered selling, sometime before the end of 2010 may be the time to do so. A capital gains tax of 20 percent (plus the 7.85 percent capital gains tax imposed by the State of Minnesota) would likely absorb a hefty portion of what’s been gained through the stock’s investment performance.

So you may want to reduce large positions now while the current 15 percent tax rate is still in effect. We think this is an especially prudent move if the long-term growth prospects of the stock are uncertain.

Dividend strategies need to be scrutinized, too, since dividend-heavy portfolios could leave investors facing more severe tax consequences. If the tax rate for qualified dividends reverts to ordinary income rates, investors in tax brackets above 15 percent will get hit on two fronts. There’s the higher tax, obviously, but there’s also the potential indirect consequence that the market may extract from the share prices of dividend-paying stocks as their payouts become less desirable on an after-tax basis. The result: fewer proceeds from your dividend—and a stock price under pressure as fewer investors want to own shares.