Should you sell stock to avoid 'cliff' tax hikes?

• If Bush tax cuts expire at year-end, taxes on stock gains and dividends will jump
• Investors with big gains must decide whether to sell now
• One strategy is to sell a piece of your big winners now

NEW YORK -- The "fiscal cliff" is to personal finance what Kryptonite is to Superman.

Indeed, in today's post-election world, if your stock portfolio has one weakness, one vulnerability, one negative financial field force that is sapping it of its normal strength, it is the long list of dangers related to the nation's well-publicized fiscal woes.

They carry the threat of recession and the potential for higher tax rates on stock profits and dividends. And that is putting investors' finances in a weakened state -- just as Kryptonite does to Superman.

The fiscal cliff is the one-two punch of tax hikes and deep, mandated spending cuts set to kick in automatically on Jan. 1 unless a divided Congress can agree on a deal to avoid, or at least minimize, the damage that the roughly $600 billion fiscal drag would inflict on the economy.

Fear that Democrats and Republicans won't get a deal done by year-end -- when the investor-friendly Bush-era tax cuts will otherwise expire -- has already resulted in a sizable hit to investors' stock portfolios. In the eight trading days since Election Day, a vote which resulted in a status quo political power structure and more divided government, the Standard & Poor's 500 stock index has fallen 4.8%.

A report of some progress and an improved tone of cooperation gave stocks a lift Friday, avoiding another down day. But some investors fear a market meltdown similar to the one that occurred in the summer of 2011, when a divided Congress brawled publicly over raising the nation's debt ceiling. The partisan bickering dragged on so long that it resulted in a credit-rating downgrade for the USA's triple-A rating, the first in history, a blow that dented investor confidence and resulted in a one-day plunge of nearly 635 points, or 5.6%, for the Dow Jones industrial average on Aug. 8, 2011.

"The market will be choppy until investors get clarity on the fiscal cliff issues," says Mark Luschini, chief investment strategist at Janney Montgomery Scott.

The direction of the market is one thing, but among other problems, arguably the biggest headache facing investors is how to protect their portfolios from a potential hike in tax rates on capital gains and dividends.

If lawmakers let the Bush-era tax cuts expire at year-end, investors will see the tax rate on capital gains, or profits from stock appreciation, rise to 20% from 15%. And for individuals with income of $200,000 ($250,000 for households), an additional 3.8% investment income tax will be tacked on starting Jan. 1 to help defer the costs of President Obama's health care law. That means high-income folks will see their capital gains rate rise to 23.8%.

Similarly, the tax rate on dividends is set to rise from 15% to whatever your ordinary income tax rate is. The nation's highest earners will see the rate jump to 39.6%. Add the 3.8% and the tax on dividends will nearly triple to 43.4% for the highest earners.

So what's an investor to do to avoid higher taxes? Here are some strategies to consider.

• Sell your big winners now, not in 2013. Let's say a year ago you were lucky enough to buy 1,000 shares of homebuilder Pulte, which turned out to be the S&P 500's top gainer in 2012. It is "prudent from a tax perspective to at least consider taking profits" before year-end and lock in the lower 15% rate rather than risk paying a potentially higher tax rate next year, says John Stoltzfus, chief market strategist at Oppenheimer.

He dubs this strategy "tax gain harvesting." It is a twist, he says, on the more traditional year-end tax-selling strategy where you sell your dogs and realize losses, which can then be used to offset capital gains and a limited amount of ordinary income.

Stoltzfus believes some of the selling since Election Day is a clear sign that many investors are already employing this strategy.

Here's how selling shares of high-flying Pulte now could save you money if capital gains taxes rise next year. Let's say you bought 1,000 shares on Sept. 18, 2011 for $5.47 a share. That $5,470 investment rose in value to $15,240 through Thursday's close. If you sell now, take the $9,770 profit and pay the current 15% capital gains rate, your tax liability for the trade will be $1,465.50. If you wait until 2013 and the rate climbs to 23.8%, your tax bill would climb to $2,325.26, or nearly $860 more.

There is precedent for selling to avoid higher tax bills later, according to a research report by Gina Martin Adams, senior analyst at Wells Fargo Securities. Following the Tax Reform Act of 1986, when the tax rate on capital gains rose to 28% from 20%, investor selling in advance of the tax hike doubled from the year prior, to $328 billion, or a record 7.4% of GDP, her research shows.

"Investor capital gains realizations were more than twice the size of any prior year, and unmatched again for more than a decade," she wrote. "Even the bubble years of the late 1990s failed to produce capital gains at so large a percentage of GDP."

But there is a caveat to this strategy, especially for long-term investors who don't need cash in the short term, warns Tim Speiss, partner and chairman at EisnerAmper Personal Wealth Advisors.

He stresses that if you like a company's long-term prospects, you might want to hold the stock, and avoid completely the taxable event caused by selling.

"Paying a capital gains tax is optional or voluntary, because you have to take the overt action of selling to incur the tax," says Speiss. "You recognize a gain no matter what the tax rate is, and you will owe tax to the government."

• Think twice before dumping dividend-paying stocks. For top earners, the tax on dividends could nearly triple from 15% to 43.4% if there is no political deal. That means high-income Americans could pay as much as $434 in taxes on a $1,000 dividend payout next year, vs. a current tax hit of just $150.

That math sure sounds like a prescription for disaster for one of Wall Street's most successful investment plays in recent years: buying stocks that pay dividends to generate income in a low-yield world. But while a tripling of taxes on so-called dividend-payers on the surface screams "Sell," a closer analysis says not so fast, according to a research report by Strategas Research Partners titled, "Dividend Stocks: Now Is Not The Time To Sell."

While they won't rule out short-term declines in the price of dividend-paying stocks, Strategas doesn't expect a draconian 43.4% tax rate to become reality. Their guesstimate: Dividends will be taxed somewhere between 15% and 28%.

Companies might also help investors by paying a so-called "special dividend," or a one-time payout, before year-end to help them avoid potentially higher taxes later. "The number of special dividends is likely to spike in the next (six weeks)," says Dan Clifton, a policy analyst at Strategas. A bunch of companies have already announced special dividends, including IDT, FedFirst Financial, NIC, Commerce Bancshares, Southside Bancshares, Sinclair and Watsco, according to Jeff Hoopes, a Ph.D. candidate at the University of Michigan. He is working on a research paper that shows there was a surge in special dividends in 2010 when it wasn't clear whether Congress would extend the tax-friendly status of dividends.

Hoopes' research also found that in 2010 about two dozen companies opted to pay their normal quarterly dividends in December rather than January to try to save shareholders money in the event tax rates went up in the new calendar year.

"Altering the timing of regular dividend payouts is pretty easy," Hoopes says.

A handful of companies is again employing that strategy. In recent weeks Leggett & Platt, Myers Industries and Homeowners Choice have all moved up their dividend payouts to avoid paying in January.

Dividends have accounted for 42% of the 9.96% annualized gains of stocks going back to 1926, according to Howard Silverblatt of S&P Dow Jones Indices.

But there is even a better reason why holding on to dividend-paying stocks, rather than dumping them for tax purposes, makes sense: History shows the market's most consistent dividend-payers perform well when taxes on dividends go up, Strategas research shows.

While higher tax rates might reduce the number of companies that pay dividends, or give companies that were thinking about issuing a dividend for the first time cold feet, it likely will increase investor demand for companies with a history of consistently paying and boosting dividends.

For example, so-called dividend "aristocrats," companies that have raised dividends every year for at least 25 years, outperformed the broad market in 1990 both one month and three months after dividend taxes were raised, Strategas says. Similarly, the aristocrats kept pace with the market after a broader 1993 increase in marginal tax rates.

"Any sell-off in dividend payers should be seen as a buying opportunity," Clifton of Strategas concludes in the report.