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With the Bush-era tax cuts possibly ending this year, now is the time to start preparing for an eventual rise in investment tax rates. Currently, the long-term capital gains and stock dividend tax rates are capped at 15%, but all investors -- especially those in the upper income tax brackets -- should prepare now for higher rates.

Even if the rates are extended another year, it appears almost inevitable given the skyrocketing national debt that investment income will be tagged with higher rates in the future. SmartMoney.com has a list of ways to shelter income from taxes ranging from selling stock winners early via '"tax-gain selling" to maxing out a Roth IRA or even the old idea of buying a house.

Buyback Advantage

One way not mentioned on that list to avoid taxes is to invest in companies that buy back stock instead of paying out huge dividends. Instead of paying taxes on those dividends every year, investors instead delay any tax payments until years down the road when or if they ever sell the stock. The investor can control when he or she pays the taxes.

Instead of getting that dividend payment, the investor obtains a larger share of the companies earnings with every net share bought by the company. These buybacks can add up over time to 10%, 20%, or even more gains in earnings per share -- all without the investor having to pay any taxes in the process.

The net buyback yield is calculated as the percentage of net stock bought by the company over the last four quarterly reports, or, in essence, the last year divided by the current market cap. The most important factor is investing in companies that have actually executed the buyback and not ones that have only announced a buyback. Unlike dividends, buybacks are a lot more flexible so they are never guaranteed.

Alternatively, investors can factor in whether a company plans to continue a buyback or whether it bought a majority of the shares four quarters ago when the stock was significantly lower. This might signal management now thinks the stock is overvalued.

Dividend-Only Stocks at Risk

This seems like an obvious concept, but most investors are now obsessed with dividend-paying stocks even though the stocks are now trading at higher valuations than the average non-dividend stock. The typical dividend stock now trades at multiyear highs with earnings multiples significantly above growth rates.

Just look at dividend stocks such as Duke Energy (NYSE:DUK) or Southern Company (NYSE:SO), trading at P/Es above 15. Do investors think these stocks will grow that fast?

If any sector or stocks are at risk for "tax-gain selling" as this year winds down, it will be the very stocks trading up on dividend highs. Remember that most dividend stocks traded very poorly as 2010 ended with the original threat of the end of the Bush-era tax cuts. The same thing could happen in 2012. Are you willing to bet the lower tax is extended?

Top Buyback Stocks

The large-cap stocks (market caps over $10 billion) with the largest buyback yields to consider are Hewlett-Packard (NYSE:HPQ), Goldman Sachs (NYSE:GS), Kohls (NYSE:KSS), DirecTV (NASDAQ:DTV), and Motorola Solutions (NYSE:MSI). See the table below for details.

Stock

Net Buyback Yield (%)

Dividend Yield (%)

Hewlett-Packard

26.0

2.80

Goldman Sachs

25.6

2.00

Kohls

20.2

2.60

DirecTV

17.7

0.00

Motorola Solutions

16.7

1.90

Conclusion

While the typical retirement investor won't be immediately impacted by having to pay higher taxes, the stocks that gained from the benefits of paying dividends over the last couple of years could be hit the hardest by these tax changes as other investors harvest gains prior to any tax increase.

Buyback stocks have the benefit of delaying the tax impact and possibly even lower comparable tax rates starting in 2013. Money will eventually go to where it is treated best, so investors need to be prepared if dividend stocks aren't treated kindly by the tax code. Not to mention buyback stocks benefit from lower equity prices by allowing the company to buy more shares at lower prices.

Disclaimer: Please consult your financial advisor before making any investment decisions.

Source: Tax Benefits Of Stock Buybacks - Large Caps