Lower tax rates on certain types of investments allow investors to take risks and drives investments in the economy. Right now, short term capital gains are taxed at your regular federal income tax rate. However, long term capital gains and dividends are taxed at a different — possibly lower — rate. However, that could change when 2010 comes to an end and the tax cuts made during the Bush years expire.

Current Tax Rates on Certain Investments

Right now, long term capital gains taxes are capped at 15%. Those in the lowest two federal income tax brackets actually pay no federal taxes on dividends collected and long term capital gains. This is an unbeatable deal for those who are just starting out with investing, or who are using dividends as part of an income investing plan. And, even though those in higher tax brackets pay 15% on long term capital gains and dividends.

New Tax Rates Dividends and Long Term Capital Gains

Starting next year, unless action is taken by lawmakers and signed into law by President Obama, the tax rates will change. The top rate on long term capital gains will rise to 20%. Those in the lowest tax brackets will have to begin paying taxes on long term capital gains (10%). The change from 15% to 20% may not seem that big, but, depending on your gains, that 5% can mean a huge difference in your real returns.

If you have gains of $10,000, the difference is $1,500 vs. $2,000. That’s $500. Of course, as gains increase, so does the difference. But the real change will be the increase in taxes paid on dividends. The maximum tax rate on dividends will head up to 39.6%. Even those in the lower tax brackets will pay 15% or 28% on dividends. For those folks, the change from 0% will be a pretty hard hit on real returns.

Watch Developments

If you are in the higher income tax brackets, paying a little more in capital gains taxes is likely to still be worth it in the long run, since paying the regular income rate on short term gains is likely to result in higher taxes when the upper federal tax rate increases to 39.6% 9 (as it could do when the year ends). For those in the upper tax bracket, dividends might as well be regular income, since that is how they will be taxed if action is not taken.

However, President Obama has promised that dividend taxes will not exceed 20%. It is important, though, to watch developments. The good news is that it is quite possible that, even if dividend taxes see a higher maximum rate than 20%, they will not go so high as 39.6%. But you never know. As always, it is a good idea to prepare for the worst, and plan for higher taxes.

If you have some long term investments that you have been considering selling, it might be worth it to consider selling by the end of the year, especially if you are in the lowest two tax brackets and can avoid paying taxes on long term capital gains. Carefully watch legislation on this issue, and be prepared for what appears on the President’s desk toward the end of the year.