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By the end of the year several major tax reductions that were enacted during the Bush Presidency are set to expire. With a major election coming up in November there will be no action from Congress or the White House until sometime in 2013. While we can be certain that tax rates will rise in 2013 we cannot accurately forecast by how much.
Here are the possible scenarios:
Nothing happens:Long-term capital gains taxes rise from 15% to 20%. Individual tax rates rise to a maximum of 39%. The tax rate on dividends for individuals earning more than $200,000 and couples earning $250,000+ will rise from the current 15% to as high as 39%. This is the worst case scenario.
On top of this tax increase, the new health care tax goes into effect on January 1, 2013 – a full year before Obamacare kicks in. This new tax is placed on “non-earned” income and includes dividends, short-term gains, and taxable interest (corporate and US Treasuries and Agencies).
So it is possible that thousands of investors will see the tax rate on their dividends rise from 15% to as high as 43%.
Here is an example of how an investor might suffer. An investor has $2 million in a dividend equity portfolio that yields 3.50% and produces $70,000/year in dividend income. Under the current 15% tax rate on qualified dividend income, the investor would owe $10,500 in Federal taxes. In 2013, if nothing changes and his tax rate on dividends increases to a maximum 43%, he would now owe $30,000 in taxes – a 200% increase.
Washington agrees to keep qualified dividend taxes in lock-step with long-term capital gains taxes: A very possible scenario is that Congress and the White House agree to keep the tax rates on dividends and long-term capital gains at the same level. In this case investors would see the tax rate on dividends increase to 20% plus the additional 3.8% tax for Medicare. Although this would still represent a 60% increase in taxes it is much more digestible than if Washington takes no action at all.
There are several important considerations around this issue:
1. Will investors remain in dividend paying stocks or reallocate to other assets?The truth is investors will get hit with the same tax rate by owning a taxable bond and would have no potential for capital appreciation. They would also hold a bond with a low fixed coupon and give up future dividend growth. An investor could reallocate to growth stocks to avoid paying the higher tax but would cut his annual income as well. If he needed to live off his portfolio for daily expenses then he would have to constantly liquidate some of his holdings. That increases his risk and taxes on short-term gains would possibly be higher than on dividend income.
2. Will companies pull back on future dividend increases?This is a possibility if the tax rate on long-term gains rises to 20% and the tax rate on dividends goes much higher. Senior management will be biased to providing its shareholders the possibility of gains over income if they believe reinvesting cash back into the business will pay off. Management may also favor stock repurchase programs over increasing its dividend.
3. Will dividends become ignored by investors?Not likely. Just ask shareholders at Apple, Dell, and Cisco who received their first dividend in company history this year.
4. What about individual investors?The truth is most retired couples do not earn more than $250,000 year and half of all dividend payments go to investors who are 65 years and older. Most of them own IRA accounts and can shift dividend paying stocks to that portfolio.
5. What about non-taxable entities, pension plans, foundations, etc.?Most don’t pay taxes and would be exempt from any tax increase.
6. Does past history offer any guidance? Regardless of the tax rate on dividend income, dividends have provided 40% of the stock market’s total return over the past 70 years. Changes to the tax rate on dividend income have normally had a short term impact on stocks that pay a quarterly dividend. Within 3-6 months after the tax rate has changed dividend paying stocks return to their true normal valuations.
At this point the market is not anticipating any change to the current tax code but investors will begin to focus on this issue after the November elections. We are monitoring the situation closely and nothing is certain at this time. Dividends are only the starting point from where we decide which stocks to own and we concentrate even more on a company’s financial health, products, management, and place in the economic cycle. We also avoid buying stocks that have dividend yields that are too high compared to the general market and which will suffer when the higher tax rates become effective.
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