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March 22, 2012, 12:01 a.m. EDT
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By Robert Powell, MarketWatch
BOSTON (MarketWatch) "” What's better? Capital gains and dividend income, or just capital gains?
News that Apple /quotes/zigman/68270/quotes/nls/aapl AAPL -0.57% plans to pay out $2.65 per share per quarter starting later this year has more than a few scurrying to answer that question.
For many years, regular Joe shareholders of Apple, which has nearly $100 billion sitting in cash, didn't really have to worry about that question. Regular Joe shareholders only had to worry about paying taxes "” depending on their tax bracket "” on their capital gains, assuming they sold their shares and assuming they actually had gains.
If you think the proposed Buffett Rule would serve taxpayers, think again. WSJ's John McKinnon joins Mean Street with details of a new study casting doubts about the proposal that would do away with the Alternative Minimum Tax.
Under current law, taxpayers in the 10% and 15% tax brackets don't pay any taxes on long-term capital gains and qualified dividends, while those in the 25% to 35% tax brackets will pay a 15% tax on long-term capital gains and qualified dividends. In essence, having long-term capital gains and/or dividends didn't really matter all that much. (Short-term capital gains and qualified dividends, by the way, are under current law taxed at a maximum rate of 35%.)
But come 2013, all that is scheduled to change, making the question about Apple and its dividend less academic. Yes, the so-called Bush tax cuts are scheduled to expire. And that has investment and tax professionals talking in general about the need to start harvesting gains "” now.
Consider: In 2013, the maximum tax rate will rise to 21.2% on long-term capital gains and 40.8% for short-term capital gains. The extra 1.2% is due to the return of the 3% disallowance of itemized deductions for income earned above a threshold, according to Bernie Kent, J.D., CPA, and managing director of Telemus Wealth Advisors.
In addition, beginning in 2013, the new federal health-care program imposes a 3.8% tax on the investment income, including capital gains, of high-income taxpayers.
"These two changes would result in a combined 66 2/3% increase in the maximum federal income tax in the long-term capital gains rates on the sale of stock in 2013 compared to a sale in 2012 (a 25% rate compared to a 15% rate)," Kent wrote in the LISI Income Tax Planning Newsletter #25. "Further, if President Obama's proposed "?Buffett Rule' is enacted, millionaires could face a minimum tax rate of 30% on their long-term capital gains as early as 2013."
What's more, starting in 2013, the distinction between ordinary and qualified dividends will disappear, and all dividends will be subject to the ordinary tax rates, which are scheduled to change in 2013 as well. Absent any legislation, the 10% rate will be collapsed into the 15% rate for 2013; the 25% rate will become 28%; the 28% rate will become 31%; the 33% rate will become 36%; and the 35% rate will become 39.6%.
And so the question of having capital gains and dividend income with Apple (or any other stock for that matter) is more than academic. Now one has to figure out what the best course of action might be. Sell this year and pay taxes at current rates? Hold and pay taxes on dividends at this and next year's rates? Or pursue some other course of action?
What say the tax and investment experts?
Well, for 2012 at least, arguably the better treatment is the dividend, said Michael Kitces, a partner and director of research for Pinnacle Advisory Group. "Those in lower tax brackets get it at a 0% rate. Those in higher brackets get it at a 15% rate. If they held onto the stock until the future, next year's capital gains tax rate is scheduled to rise to 10% for the lower brackets, 20% for the higher brackets, and 23.8% for the highest brackets due to the new Medicare tax on unearned income."
On the other hand, Kitces said, dividends next year are scheduled to revert to ordinary income, "a far less favorable treatment than capital gains, even capital gains at higher rates."
So, the optimal course of action "” from pure tax efficiency point of view "” would be to keep the value as a capital gain and not a dividend, and harvest the capital gain this year at current rates, Kitces said.
"That way you can take advantage of the current rates this year, but keep the preferential capital gains treatment in future years instead of being "?forced' to take a higher-tax-rate dividend," said Kitces, who is also publisher of the Kitces Report.
Read Kitces' report on the tactic of harvesting gains at this website.
Others agree with the general strategy of harvesting gains this year. "The likelihood for significant increases in the long-term capital gains rates would suggest that taxpayers recognize their long-term gains in 2012 and hold off on selling their losers until 2013," Kent wrote in his report, noting further that taxpayers should even avoid the active harvesting of tax losses that might otherwise be a part of their investment strategies.
But this isn't only about tax efficiency. "Apple is sitting on a giant pile of idle cash," said Kitces. "Cash is earning less than 1%. So in essence, that's like having a portion of my Apple investment tied up in cash. If Apple distributes the dividend to me, I can reinvest it for potentially much higher returns, and in the long run I'd still come out ahead investing the dividend after taxes into higher return vehicles than keeping the dividend in Apple at capital gains rates but a very low return."
Of course, Kitces said this is part of an overall economic discussion that has been debated in finance circles for many, many years, whether it's better for companies to give a dividend to investors for them to invest themselves, or whether it's better to let the company keep the dividend to invest on the investor's behalf.
In Apple's case, after years of investing on the investor's behalf with hard-to-argue-against results, the board's likely decision to pay a dividend just might be an admission that shareholders and not management can put at least some of Apple's cash to better use.
But that's a debate best left for another day.
Robert Powell is editor of Retirement Weekly, published by MarketWatch. Learn more about Retirement Weekly here. Follow his tweets here.
Robert Powell has been a journalist covering personal finance issues for more than 20 years, writing and editing for publications such as The Wall Street Journal, the Financial Times, and Mutual Fund Market News.
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