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By Jeremy Glaser and Josh Peters, CFA | 11-09-2012 12:00 PM

Don't Shun Dividends if Tax Rates Rise

Compared with other investments, the income consistency that dividends provide on a pretax basis allows them to retain their value and practicality even if tax rates increase, says Morningstar's Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He's the editor of Morningstar DividendInvestor. We're going to look at some hot dividend topics.

Josh, thanks for talking with me today.

Josh Peters: Good to be here.

Glaser: So, let's start with the election. One of the things that we've been talking about for quite a while now is what's going to happen to the dividend tax rate, particularly in relation to the capital gains rate, after 2013. So, now that we know that the status quo, at least in terms of both houses of Congress and the White House is going to stay the same, do we have any more clarity on what's happening there?

Peters: Not a whole lot. If one political party or the other had swept the elections, I think then you could say things were a little bit clearer, but we have very much after $6 billion spent in this campaign returned the same group of people essentially more or less to Washington. It seems to be our form of revenge. This is how we get back at these politicians for making us watch all those horrible ads, is that we lock them up for kind of a cage match.

I think it's good to start with where we're at now, what's going to change on Jan. 1. Dividend income will again be taxed as ordinary income, and long-term capital gains, which right now is also taxed at 15%, like dividends are, will go to half of whatever your ordinary income tax rate. And then on top of that for high-income earners, already as a part of current law, there is another 3.8% tax to support the Affordable Care Act provisions. Of course, I can say Obamacare now right, because even the president calls it Obamacare. So, that tax increase is pretty much baked as they say.

The other two are still in flux, and I think that the most likely outcome is still what I saw a few months ago or even a year ago, which is that upper-income tax payers probably will wind up having to pay somewhat more, but that by the time all of the horse trading is done and we have a more comprehensive, more durable reform package, we should see dividends and capital gains still taxed at the same rate for everybody. Some people's marginal tax rate it might go from 15% to 20%, but I think for the most part, the idea of having it go to 39.6% I think most people understand that, that's not a real good idea at this point.

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