The Obamacare Tax Surprise

July 02, 2012

In all the hoopla over ‘Obamacare’s’ potential impact on health care premiums and insurance companies’ bottom lines, people seem to have overlooked a key passage that raises the tax on investment income.

That’s right—taxes are going up by 3.8 percentage points on all joint filers with adjusted gross income of more than $250,000 and on single filers with incomes over $200,000.  These changes are going up next year—a full year before the health law is scheduled to take effect.

The additional tax will likely apply to dividends, interest (excluding municipal bond interest) and short- and long-term capital gains, according to the Wall Street Journal.

This additional tax could potentially have a significant impact on all the dividend-focused ETFs that have been so popular lately.

A 3.8 percentage point tax hike may not seem like a big deal until you consider it in the context of tax rates as they currently stand—and what they could rise to if the Bush-era tax cuts aren’t extended.

Currently, dividends are taxed at 15 percent, and will be taxed at 18.8 percent starting next year if the Bush tax cuts are extended.

If the tax cuts aren’t extended, however, the dividend tax rate could rise to as much as 43.4 percent. In comparison, long-term capital gains rates would rise to just 23.8 percent, making companies and funds that don’t pay out investment income much more attractive.

High-income-producing ETFs may also lose assets, as high-tax-bracket investors flee to municipal bonds or lower-yielding funds, which could potentially dry up liquidity and increase trading costs.

At the most extreme, high-dividend-paying companies may lower their dividend payouts, as executives at the top who are paid mostly in stock seek to avoid the added dividend tax.

Now is a good time to take a close look at your portfolio and determine what your tax liabilities could become next year and whether your portfolio will still make financial sense under the two possible tax scenarios.

Over the past year, the iShares Dow Jones Select Dividend ETF (NYSEArca: DVY) paid out $1.85 per share in dividends.

So, if you held a $100,000 position in DVY, you received about $3,290 in dividends. If DVY were to pay out comparable dividends in 2013, you would be on the hook to Uncle Sam for about $1,500 if the tax cuts are not extended, or $620 if they are.

And, as long as I’m parsing tax liabilities, under current rules, you’d owe about $500.

Keep an eye on Congress as it debates whether to extend the tax cuts­. If you’re in the top tax bracket and own high-income-paying ETFs, your tax bill next year could go up significantly.

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