Investors Wary of Tax Brawl

NEW YORK (TheStreet) -- No matter the outcome of the midterm elections next month, investors need just one more thing out of the lame-duck Congress before year-end: A decision on taxes.

With a screeching deficit and "Bush-era" tax provisions set to expire at the end of 2010, lawmakers began rumbling about taxes long before heading to the campaign trail. The Obama administration would like to extend policies that are beneficial to the middle-class, but cut others that have helped wealthy Americans. Perhaps unsurprisingly, Congress is split on the issue.

If Congress does nothing to extend tax cuts implemented under President Bush, income tax rates will run higher. Tax rates for most people will rise by three percentage points next year. Top earners - households that make more than $250,000 a year and face the highest tax rate - will rise from 35% to 39.6%, then up to 40.5% in 2013.

Of particular concern for investors are potential tax hikes on dividends and capital gains, both of which now stand at 15%. Dividend rates will rise to the same income-tax rate as the filer pays, while capital-gains will be taxed at 20%.

This year, equity returns had been sluggish until the September rally, with bonds seeing most of the inflows from big mutual funds. Investors who did remain bullish on stocks have been heavily reliant on dividend-payers. Blue-chips with big dividends, like AT&T (T), Verizon (VZ) and Pfizer (PFE) have outperformed the market by a wide margin since mid-year, while other Dow stocks with weak dividends like Bank of America (BAC) and Hewlett Packard (HPQ) have lagged.

"With bond yields at record lows and confusion about where equity prices are headed, there is increasing interest in high-income or high-dividend stocks," Jan Loeys, who oversees global asset allocation at JPMorgan Chase (JPM), said in a report Friday afternoon. "Overweighting high dividend-yield stocks is a good long-term strategy as on average they outperform lower-yield stocks by close to the differential in dividends."

Greg Rosica, a tax partner at Ernst & Young, says investors have had to plot out two different courses - ready to pull the trigger on either once Congress decides its tax strategy for 2011.

If lawmakers decide to halt tax breaks on cap-gains and dividends next year, then investors should cash in on capital gains this year and hold off on recognizing losses until 2011, Rosica says. If Congress extends all tax cuts into 2011, then investors can put off the portfolio shifts until later. Rosica says taxpayers may also want to consider shifting retirement portfolios into tax-deferred accounts, like Roth IRAs.