Are your stocks paying a special dividend to avoid taxes?

I hope you enjoyed my recent series of articles on net worth. I’ll definitely revisit the topic in the future. But right now, I wanted to address something else that has been happening recently.

An interesting phenomenon is happening. Many companies are paying special dividends as the year comes to a close. In fact, I just saw an article where the Washington Post Co. is planning to pay it’s entire 2013 dividends on December 27, 2012. Some but not all companies are paying an extra dividend.

The companies that are doing this are trying to hedge the risk of Congress not reaching a deal over the so-called “fiscal cliff” and thus seeing tax rates go up on January 1st. This especially extends to taxes on dividends. Right now, unsheltered dividend income is taxed at 15%. If nothing happens, then it will go back to up to the owner’s regular income tax rates next year.

What does this mean for a long term dividend investor?

I’m definitely one of them, even if stocks aren’t a majority of my investment portfolio. How am I prepared for these new tax rates? Well, I have rebuilt my investment portfolio to be tax smart.

  • Most of my stocks are inside a Roth IRA, meaning any dividends I receive are not taxed.
  • I have units of an MLP in a non-tax sheltered account. MLP dividends are mostly tax free and don’t benefit from IRA shelters.
  • Real estate depreciation doesn’t appear to be on the table, and most of my depreciation only shields rental income.
  • And I haven’t heard anyone talk about adjusting tax laws in regards to EIUL policies, so that is secure for now.

This means I have things structured so that most of my wealth building won’t be impacted heavily by these daily headlines.

I used to invest in mutual funds wrapped in a 401K and also had some stocks, but I didn’t really know what I was doing, because I didn’t take an active role in researching things. If you pulled me over and asked me what my long term wealth plans were, it wasn’t more than, “throw money into my 401K.” On rare occasion I looked at the stocks that I owned and made changes, but not many.

Now I monitor things much more closely. I only have five stocks, which means I can keep track of them. None of them appear to paying a special dividend, but I’m watching for any announcements.

Bottom line

Essentially, my biggest exposure is going to be any rising income tax rates and social security tax rates on my active income from my job. If you read The Millionaire Next Door, one key thing that is pointed out is that most millionaires don’t earn a $1 million/year, but instead have a net worth exceeding $1 million. Most of these millionaires aren’t high income earners like doctors and lawyers. This lets them duck the high marginal tax rates while building business equity, real estate holdings, and strong stock portfolios.

So what changes do I have in mind if taxes go up next year? Not many. I would normally be concerned if one of my stocks decided to stop paying dividends. One of my key criteria in stock selection is to pick one that not only has a history of paying dividends but also of increasing the dividends every year. If one of my stocks decided to pay all of its 2013 dividends in the next couple of weeks, I will keep an eye on it, to see if they resume regular payments in 2014. If they put on the brakes, then I will do more research at that time to see whether to keep it, or close my position and hunt for a replacement.

While Apple has started paying dividends, I don’t treat it the same way. I bought it for appreciation. Berkshire Hathaway doesn’t pay any dividends so it isn’t subject to the new dividend tax rates either. Both of these positions are based on the long historical growth they have exhibited, and the fact that they aren’t my at the top of my wealth building plan. Is your wealth building plan setup to take some knocks? Send me a message and we can talk about it.

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