A Secret "Health Care" Provision That Could Lead To a $5,867 Tax Increase

By Nathan Slaughter

This article isn't about health care per se, at least not directly. Rather, I want to talk about a hidden provision that snuck in the back door during the reconciliation process, when certain "fixes" were made to push the bill through. Specifically, a provision that imposes a 3.8% surcharge on dividends and capital gains for those who have incomes high enough to qualify them as "wealthy."

I'm not here to draw lines in the political sand. But from an investing standpoint, this tax hike is insidious -- and could easily short-circuit this fragile recovery from the steepest stock market crash on record.

First, let's not forget that profits are taxed on the corporate level at 35%. What's left to distribute to shareholders is taxed again as dividend income. In fact, this double-taxation is a big reason why rates were slashed back in 2001, during the Bush administration.

With the Bush tax cuts set to expire and no indication from Congress that they will be extended, you might want to enjoy today's 15% dividend tax rate. If the tax cuts made in 2001 are allowed to expire, the aforementioned wealthy, defined as individuals earning over $200,000 per year and couples earning over $250,000 per year, will be saddled with a 20% dividend tax next year and a 23.8% rate soon after.

If all these tax hikes go into effect, a $10,000 tax on dividends and capital gains today could be a $15,867 tax bill on the same dividends and capital gains by 2013, the year the health care surcharge is scheduled to begin. The $132 billion projected to be pulled from investors' pockets during the next decade is earmarked to help keep Medicare solvent, assuming that Congress can keep their hands off the slush fund it's being deposited into.

Unfortunately, history suggests the higher tax won't even do much to bring in additional revenue. Believe it or not, taxpayers adjust their behavior to changing tax climates. When higher capital gains taxes are on the horizon, investors are inclined to sell stocks to take advantage of the lower rate while it's still in effect. Then, once the inventory of unrealized gains is depleted, they sit tight.

The last time we saw a capital gains tax hike of this magnitude was in 1987, when the capital gains tax was increased from 20% to 28%. Predictably, tax receipts jumped in 1986 just before the change took hold, but then they slumped and didn't return to their pre-hike levels for more than a decade.

When President Clinton lowered rates back down to 20% in 1997, we saw the opposite happen -- money began pouring into the Treasury. The same thing happened after rates were further dropped to 15% in 2003. In fact, the Wall Street Journal reports that revenues from capital gains spiked from $49 billion to $118 billion within four years.

My point isn't to stir up a partisan debate. You can draw your own conclusions about whether the new tax policy is an economic roadblock or a step in the right direction. My intent is to let you know that changes are coming -- and it's never too soon to take pre-emptive portfolio action.

First, take steps to keep income-producing assets and high-turnover funds in IRAs and other tax-qualified accounts.

Second, note that punitive tax rates can do nothing but help one often-forgotten asset class -- municipal bonds.

Back in November 2008, I wrote about three areas that stood to gain from the policies of newly-elected President Obama -- and one of those was tax-free munis. Investors are a pretty smart bunch and will adjust their playbook to take advantage of game-changing tax laws, going on offense when taxes are eased and defense when they are tightened.

You can bet that big investors will be looking to shield more of their income from Uncle Sam. If you live in a state with high taxes (and sound financial footing) it might make sense for you to consider a state-specific muni, since interest earned from munis issued within your own state are generally (but not always) exempt from federal, state and local taxes. If you live in a state with low or no state income tax, a diversified portfolio of debt from around the country might be a better bet.

There are a number of muni bond funds and ETFs available to the individual investor, like the Blackrock Muni Intermediate (NYSE: MUI), a closed-end fund that offers exposure to a well-rounded basket of bonds issued by creditworthy agencies. The fund is trading at an attractive 4.3% discount to NAV, invests primarily in AA and AAA-rated securities, and offers a robust payout of 4.8% -- for a tax-equivalent yield (TEY) of 6.8% for those in the 35% bracket. Plus it scores in the top decile of its peer group by outrunning nearly 90% of its category rivals during the past five years.

With various tax hikes on the horizon, there's no time like the present to begin preparing for the onslaught of higher taxes.

If you are interested in learning more about investing in municipal bonds, check out our educational article on the subject, The Safe Haven of Municipal and Local Bonds.