The Fiscal Cliff has been getting all of the attention as of late, and for good reason. Unless our leaders in Washington can reach a resolution soon, with each passing day, it is looking more and more likely that we will indeed drive right over the cliff.
In short, unless a compromise is reached by Congress before the end of the year, starting at midnight on December 31, 2012, the Bush-era tax cuts will expire, and ~$600 billion in tax increases and spending cuts will go into effect.
Here is a chart breaking down the current law for dividend taxation:
As you can see, qualified dividends are currently taxed at 15% (for investors above 15% income tax rate), as opposed to the higher ordinary income tax rate. Excluding the lowest two tiers on the income tax bracket, this basically means that everyone is paying the same 15% tax rate on their dividends.
At this point in time, paying taxes on qualified dividends is no different than paying taxes on long-term capital gains (stocks held by investor for more than one year prior selling). So, regardless of which investment strategy you decide to use, you will end up paying the same percentage on taxes. From a tax perspective, there is no advantage to collecting dividends over selling for long-term capital gains, or vice-versa.
As a dividend growth investor, any changes in tax laws that would impact dividend payouts concerns me. If we do go over the cliff, the tax treatment on dividends, starting in 2013, will change substantially:
From the chart above, we can see that there will no longer be any distinction between qualified dividends, ordinary dividends, or ordinary income tax. Simply put, dividends will no longer be taxed at 15%, but at an the ordinary income tax level.
The following chart breaks down income tax for each bracket:
In addition, single filers making more than $200,000, or households earning over $250,000 will be subject to an additional 3.8% Obamacare tax, which is an additional income tax levied on dividends, capital gains, and interest.
If the Bush tax cuts are allowed to fully expire, then the dividend tax rate will increase from 15% to 43.4% for those in the top bracket, earning more than $398,500+.
For myself, the worst-case scenario would be: my dividend tax rate increases from 15% to 31%.
If the Bush tax cuts are extended: my dividend tax rate increases from 15% to 28%.
My immediate reaction with the increase in dividend taxes has nothing to do with how much more in taxes I will personally have to fork over. Actually, I’m not too overly concerned with the fiscal cliff, but if I were to play devil’s advocate:
Capital Gains Appeal
As previously mentioned, as of 2012, there is no difference in taxation between qualified dividends and long-term capital gains. They are both taxed at the 15% rate. Going forward in 2013, dividends will start to become taxed at the income level rate. However, the same won’t be happening to long-term capital gains. In fact, long-term capital gains will top out at 20%. Here are the tax rates for capital gains:
Under full expiration of the Bush tax cuts, most investors will pay between 28% to 39.6% in dividend taxes. In contrast, long-term capital gains will only be taxed at 20%, which is obviously more attractive.
If capital gains become more appealing to investors, will companies feel more compelled to use earnings to buyback shares?
If so, what will happen to the dividends? As a shareholder, you can be certain that I want my fair share of the pie. I want my dividends and I want my dividend payouts to keep growing at a robust rate every year. With the new tax rates, though, I do start to wonder whether or not some companies will elect to slow down the rate of dividend growth in favor of share buybacks. Even worse would be if the Board decided to keep the extra cash and invest it “wisely” back into the company.
Tinkering of the Formula
We are already seeing a reaction to the fiscal cliff, as companies like Walmart (WMT) and Cisco (CSCO) have announced changes to their dividend schedules. WMT and CSCO moved up their dividend payouts from January 2013 to December 2012 in an attempt to maximize value for shareholders. By paying out distributions before the impending tax changes go into effect, shareholders will get to benefit from the lower 15% qualified dividend tax rate one last time. Companies like Costco (COST) are even making special dividend payments ahead of the fiscal cliff to offset some of the higher tax “damage”. COST is even willing to take on more debt to fund this special payout.
As an investor, my ideal strategy is to pick a plan (dividend growth investing) and stick with it from start to finish. I like routine and consistency. The last thing I need (or want) to see are companies tinkering around with the formula. It’s a small gripe, but I don’t like to see my dividend payout schedule changing. Taking on debt to fund a special dividend seems like a bad idea as well. If this is just the start, I worry about what’s in stored for later. An overreaction may cause a company to try and fix what ain’t broken.
Investors in the top income bracket will be most affected, since their dividend tax rates may potentially increase from 15% to 43.4%. These are the same folks who also own the most shares, have the most money invested, and wield the the most influence.
Most everyone thinks that the rich need to pay more in taxes. However, if you keep taxing these folks more and more, they’ll eventually grow tired of the game, and decide to take their ball home instead. When the return on investment loses its appeal, they’ll pull their money out, and find someplace else to invest. If this happens, what will be the impact on the market? Will we see an exodus of dividend investors? Is another market sell-off in the works?
Stick to the Plan
No one wants to pay more taxes. Period. But, regardless of whether or not the Bush tax cuts are extended, my dividend tax rate will probably increase from 15% to 28-31%. Since I am not a top income generator, the new tax rate really doesn’t impact me too greatly. Luckily, I don’t make enough to qualify for the Obamacare tax. Here are the reasons why I’m sticking with dividend growth investing, in spite of any impending tax hikes:
I am an investor for the long haul. I must remember this, first and foremost. Just like with any diet plan worth following, you won’t get the results you’re after by changing your strategy everytime the going gets rough. I am a dividend growth investor. That is my strategy and I’m sticking to it.
The Fiscal Cliff of 2012 may seem like a big deal right now. But if an agreement is reached, and the crisis is averted, will anyone even remember this event 20-30 years from now? Further, tax laws are always changing, and always will be changing. This isn’t the first time that rates have been increased. And it won’t be the last time either. See the following chart below:
Sure, in the short-term, companies may reduce the dividend growth rate. Capital gains may even take on a more prominent role for investors if their tax rates become advantageous to dividends. But this won’t last indefinitely. Investors, particularly income investors, will always demand to get paid. So, nothing beats dividends. And companies like: Coca-Cola (KO), Johnson and Johnson (JNJ), McDonald’s (MCD), AT&T (T), and Emerson Electric (EMR) have the time-tested history to back up this claim. Through the worst of economic recessions and depressions, the best companies always managed to find a way to keep paying those dividends without fail.
If the Bush tax cuts expire, I’ll have to pay more taxes on my dividends. Is this a big real right now? No. My time horizon is many years away, so I’m still very much in accumulation mode. Who knows what the tax rates will be like by the time I’m ready to retire? They could very well decrease again. The important thing to do right now is build up my portfolio base. This means buying more shares. Lots more shares.
I raised a concern about a potential sell-off in dividend stocks that might occur in the event we go over the cliff. At first glance, this might seem to suggest that I’m particularly worried about capital gains, or share prices. But what I’m really concerned with is market timing. If dividend stocks do in fact sell-off, then I want to make sure that I’m well positioned to make a big splash. As such, at this moment in time, I am working towards building up my cash reserves. I don’t have a crystal ball, but I’m pretty certain that if I invest in the aforementioned companies (at attractive prices), I’ll be better off in the long run.
The Fiscal Cliff has been garnering all the media attention, and will continue to do so until either a resolution is reached, or the tax cuts expire. In any event, as a long-term dividend growth investor, I don’t plan on making any changes to my strategy.
If a compromise is reached, then nothing changes, and I’ll keep on periodically buying quality dividend stocks. If the tax cuts expire and there is a mass exodus of investors moving away from dividend stocks, then I’ll simply load up on the discounts.
My fundamental plan has always been to build up a passive income stream to allow me to fund early financial independence. The Fiscal Cliff is more short-term news than anything else. As such, nothing changes, and I proceed as normal. And so, the journey continues…