In current financial news there has certainly been plenty of discussion of what the future tax burdens will be for many Americans across the country in 2011. For instance, it has been known for some time now that there will be rate increase for long-term capital gains in the new year. This means that the 0% rate will be removed and the 15% tax rates will increase to around 20%. In perspective, this really isn’t that high of a tax hike when you consider how low the current rates are at present. However, fewer have discussed the increases expected in dividend tax rates in 2011.

photo credit: MyTudut

The New Terms

At this point, dividends are scheduled to return to more ordinary tax rates; in other words they will be rising. Depending on the individual there could be some serious effects on what amount of taxes you will have to pay on your dividends. This would also mean a reduction in relative rates of return and one’s net fixed income levels. The rates on dividends could get exceedingly high. Of course, with the controversy surrounding the expiration of the Bush-era tax cuts taking center stage in recent months, the issue of dividend tax rate increases didn’t rank high in Senate Finance Committee’s priority list.

Preparing For The Tax Hike

First, keep in mind that the extent of the rate hike is not currently know. All one can do is speculate at this point. This means that any plan you make includes a bit of guess work. There are a few options that might seem to make the most sense given the situation. Obviously, it is wise to exercise prudence and avoid making rash decisions based on speculation. The dividend tax rates are just one factor that must be included when trying to make a sound investment decision. Still, there are some options that you might want to consider further so you have some idea about what to do with your 2011 investment portfolio.

Options

Replace dividend paying stocks with something else – In this context, it might make more sense to change up your portfolio to include a selection of other financial investment tools. One good example is the municipal bond. These tools are issued by the city, county, and state governments and offer less risk than equities. The investor will not have to pay federal tax, state, or local taxes on the interest income either. There are also REITs or real estate investment trusts. Through these tools you can get better than market value on your dividends. Of course, you may still have to pay the regular income tax rate for the distributions unless they qualify at capital gains rates. Plus, REITs may make return of capital distributions that not taxed.

Considering Stock Prices

Lastly, be aware of the fact that if the tax rates are increase, the dividend paying stock prices may experience decreases. There are no surefire ways to determine how much they might drop since we cannot be absolutely sure what the dividend tax rate will be either. You have to be prepared for different results. This may be why some financial experts suggest hedging your exposure. By selling the higher dividend yielding stocks you could put it on a different investment stock to protect some assets.

photo credit: .Larry Page

In recent months, many dividend paying stocks, along  a favorite of investors, have been hit during the world wide financial crisis, and have cut their dividends. As a result, a number of mutual funds that invest in these stocks have also reduced their dividends. What does this mean to you, the shareholder, in these funds? Expect more dividend cuts for these, and other funds, are possible as the year unfolds. The dividend changes reflect the recent, and anticipated reduction in dividends paid by companies in 2009, in  the current low interest rate environment. Let’s take a closer look at why the dividend cuts have occurred, and where dividend investors can go from here.

What Happened to the Dividends?

In 2008, battered by the global recession and credit crisis, firms in the unmanaged S & P 500 cut their dividends by a record 40.6 billion in aggregate, or $4.70 per share. This year is worse. As of April 30, 2009, the cuts already have reached 45.1 billion. To gain some perspective, according to a few mutual fund managers who focus on dividend paying stocks say the economic environment has been so tough, and profits have declined so rapidly, that they’ve seen companies in the United States and overseas reducing or eliminating dividends in a way that we haven’t experienced since 1942. Ouch!

Companies that were thought to be essential parts of the American economy, quickly disappeared, or underwent drastic restructuring.  Several firms here and abroad with long histories of paying dividends suddenly decided they needed to conserve money to survive. At the same time, bear markets tend to remind managers and investors of the value of dividends. When stock prices are going down, and the only bit of positive return you’re getting is from dividends, it gets people’s attention and awakens them to the long-term value of those dividends. Contrary to popular belief, not all companies are slashing dividends. In fact, 68 companies across 9 industry sectors in the S&P500 have raised their dividends by an average of 8% in 2009 the S&P reports. In addition,  some companies that have never paid dividends in their corporate history are declaring a dividend for the first time.

Why do most mutual funds that invest in dividend paying stocks need to reduce their dividends?

It’s important to understand that mutual funds pay dividends based on dividends and income from its investments. An operating company can decide to retain earnings, or it can make a decision to pay dividends out of retained earnings, which makes the profit. So, an environment where companies are cutting their dividends, and a fund is receiving less  income, the mutual funds is going to reduce its dividends.

Why didn’t dividend stocks act as cushions during the current stock market decline, and protect shareholders on the downside?

Typically, income funds and income producing stocks haven’t fully participating in raging  bull markets, but they also haven’t suffered as much in the market downturn. This time was different for two reasons. First, income producing stocks did participate during the upside. Second, the market bubble at the root of the current decline was centered on an industry of high yielding stocks  financial service companies . When the bubble burst, the cornerstone of income producing stocks suffered most.

What is the outlook for dividend focused mutual funds going forward?

Historically, dividend paying stocks have made solid gains early in any recovery as investors are attracted to the steadier streams of income from these securities.  While it’s easier to focus on how many companies have cut their dividends, it’s important to remember that there are at least 40 companies in the S&P 500 that have raised their dividends every year for the past 25 years.  These companies have sustainable earning streams.

What should you do as a shareholder?

Historically, many funds provided a rising income stream to shareholders who reinvested their capital gain distribution and took dividends in cash.  Find out more about what is a dividend before you actually invest.  Investors whose overall income from this fund and other sources are down may have to make some adjustments to spending priorities.  Also, consider looking for mutual funds or ETF’s that have a history of increasing their dividends.  Believe it or not, but those investments are out there.  Happy hunting!