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A couple of months ago, I wrote an article here discussing potential ramifications from changes in tax policy over the next couple of years. With the apparent failure of the so-called supercommittee to arrive at any meaningful alternatives for deficit reduction much less tax policy, the likelihood that the Bush tax cuts will expire at the end of next year has increased.

This expiration would, among other things, result in dividends being once again treated as ordinary income and being subject to the higher marginal tax brackets that were in effect prior to 2001. So what is one to do? Rather than rehash the points that I made in my previous article, what I have done and I would recommend to others is to take out your federal 2010 tax return and do the following:

1. Look at line 9b of your 1040 for your total amount of reported "Qualified Dividends".

2. Look at line 43 to see what your taxable income was.

3. Go to this website to see what your marginal bracket was for 2010 based on your taxable income.

4. In the same website lower down, see what the equivalent marginal tax rate was for the same bracket for the 1993 - 2000 period.

5. If you are currently in the 25% or higher marginal tax bracket, subtract 15% from the 1993 - 2000 equivalent marginal tax bracket. If you are in a marginal tax bracket below 25%, please do not use this procedure to make an estimate

6. Finally, multiply the percentage differential arrived at in "5." above by the above amount from line 9b of your 1040.

For example, if I had $20,000 of Qualified Dividends in 2010 and my taxable income was $90,000 (25% marginal tax bracket if married and filing jointly), with the Bush tax cuts expired, my additional taxes would have been $2,600 (ouch!) as the difference between the equivalent 1993 - 2000 bracket of 28% less the current dividend tax rate of 15% equals 13%.

This 13% differential multiplied by the $20,000 of Qualified Dividends equals $2,600. This would mean that I would need to find $3,611 of additional pretax ordinary income to end up in the same place ($2,600 divided by 0.72 which 1 minus your now 28% marginal tax rate). Extending this, if $20,000 of Qualified Dividends represented a 4% current yield on my dividend stock portfolio (implying a $500,000 portfolio in a taxable account) and I was relying on my dividend stocks in this portfolio to make up this difference, I would have to increase this current yield to 4.72% (an over 18% increase) just to stay even. (*see note below)

This calculation gives you a very rough approximation of the additional tax you would owe related to the taxation of qualified dividends as ordinary income if the Bush tax cuts expired without amendment or substitution. As there are many other factors that could affect this calculation such as being on the edge of a bracket, a material change in income or deductions between 2010 and 2013 and/or being subject to the alternative minimum tax to name just a few, I strongly recommend that you discuss this with an accountant or financial planner for further clarification.

If you do this, at least you will have a very general idea how this eventuality might affect your specific situation. This allows to you consider contingency plans if necessary such as identifying possible reductions in living expenses, looking for higher current yielding dividend stocks and/or adding some other investments such as high yield bonds that would then have the same tax treatment as dividends and/or municipal bonds which are, typically, tax exempt. You don't need to make these moves right away, but if we get into 2012 and this is still not resolved, you will want to be proactive not reactive. Let us hope that this does not come to pass...

* Please note this does not account for the additional 3.8% tax for so-called Obamacare that also kicks in for 2013 for higher income people. Please see my original article for a brief discussion of this.

Source: Dividend Stock Holders: Preparing For The Expiration Of The Bush Tax Cuts