Chart investment strategy now for 2011 tax changes

The months and weeks leading up to the end of the year could see more than the usual turmoil in the stock market as investors, guided by their financial planners and investment advisers, adjust their portfolios ahead of

the new tax environment that they will face in 2011.

Investors and their advisers should be planning their moves now — not waiting until the last moment.

One big movement could be out of dividend-paying stocks because the double taxation of dividends, greatly reduced by the Bush administration’s tax cuts of 2003, will return in force next year.

The 2003 tax cuts, which were designed to offset the impact of the bursting of the technology bubble and the Sept. 11, 2001, terrorist attacks, reduced the tax rate on most ordinary dividends to 15% from the rate that taxpayers paid on ordinary income.

That equalized the tax treatment of dividends and long-term capital gains, which also were taxed at a 15% rate, making investors favor neither dividends nor capital gains. Previously, the tax disparity encouraged investors to favor capital gains.

With the expiration of the 2003 tax cuts, dividends again will be taxed at a taxpayer’s ordinary tax rate. For the wealthy, this could be as high as 39.6% and could rise as high as 43.5% when the tax imposed on couples who earn more than $250,000 a year to pay forhealth care reform goes into effect in 2013.

This once again will give the United States one of the highest dividend tax rates in the industrialized world.

Long-term capital gains will be taxed at a 20% rate rather than the current 15% rate, though again, for couples who earn more than $250,000 a year, the additional 3.9% medical-reform tax also will be imposed, still far lower than the rate on dividend income.

Some academics have long argued that taxing dividends is unfair because it taxes at the individual-shareholder level income that already has been taxed at the corporate level, as dividends are paid out of after-tax corporate profits. Some also argue that by favoring capital gains over dividends through lower tax rates, tax policy could encourage companies to pursue growth at any cost to generate the capital gains.

Those in favor of taxing dividends as ordinary income argue that it is unfair social policy to tax income generated from work more highly than income generated from investing. In response, those opposed to the dividend taxes argue that the dividend income often results from years of saving and investing the after-tax income generated from work.

Whatever the merits of these arguments, the changing tax treatment of dividends no doubt will produce changes in investors’ behavior — and possibly in the behavior of corporations.

The increase in the taxes on dividend income, besides encouraging investors to favor capital gains over dividends and driving down the stock prices of dividend stocks, might encourage more investors to favor tax-exempt bonds.

However, the prospect of higher inflation that is likely to result from unprecedented federal spending and the easy money policies of the Federal Reserve makes municipal bond investing a risky strategy. Inflation could drive up interest rates, reducing the value of existing bonds, while at the same time eroding the purchasing power of the current interest payments.

Corporations will feel less pressure to increase dividends and may even reduce them to husband capital for use in financing faster growth and generating capital gains.

This tax change and the turmoil likely to result from it offer no consolation to investors. It does, however, enhance the value of accountants, financial planners and investment advisers who help their clients wade through it.