(Dow Jones) As speculation mounts that U.S. lawmakers will let Bush-era tax cuts on dividends lapse, some wealth managers are considering revising clients' portfolios to minimize the tax hit.
For the past several years, wealthy investors have gotten a break: Certain dividend payments once treated like other income have been taxed at a lower rate, putting them more closely in line with capital gains. The benefit is set to expire next year, meaning the rate on these dividends would jump to a maximum of 39.6% from 15% if nothing is done.
President Barack Obama's budget calls for a top tax rate on dividends of only 20%, but some Democrats believe that's not stiff enough. There's also no guarantee Congress will act at all, a possibility that looms especially large given that Washington has already allowed the estate tax to temporarily expire.
Whatever the outcome, it's likely to change wealth managers' investment calculus.
"Everything we do for clients is on an after-tax basis," says Jack Ablin, chief investment officer of Harris Private Bank. "It could prompt an asset allocation shift away from equities."
Ablin notes the yield on Utilities Select Sector SPDR (XLU), an ETF crammed with dividend-paying stocks, is about 4.1%. That translates to an after-tax yield of about 3.5% with a tax rate of 15% but only 2.5% at a rate of 39.6%. Meanwhile, he says, the yield on the iShares S&P National AMT-Free Municipal Bond ETF (MUB) is 3.5%; therefore, a tax change could well make a bond investment more attractive.
Of course, Harris would also have to consider whether selling stocks and buying bonds in their place would prompt capital gains taxes, offsetting part of the benefit. Ablin says the firm will make any moves by the end of the year-capital gains tax rates are also likely to spike -but doesn't want to do so now because no one knows what Washington will ultimately decide.
Brentwood, N.H., financial advisor Howard Cadwell plans to help clients avoid the looming tax hike by rejiggering their portfolios. His strategy is to move dividend investments into individual retirement accounts where a new dividend tax rate wouldn't matter. Assets and earnings in a traditional IRA grow tax-free until investors begin withdrawals, at which point they pay tax at regular income rates.
Of course, a downside is that some investors' IRAs are small relative to their other holdings, and Cadwell has already enlisted these accounts for other income-oriented investments. "In some cases, they're filled up with bonds," he says. "There's no room."
Not everyone plans to start making trades. Linthicum, Md., financial adviser John Bacci opposes the tax change "philosophically" but plans to keep dividend stocks because he's optimistic the economy will recover and wary of rising interest rates. Both factors might lead stocks to outperform fixed-income alternatives.