Dividend Growth Investing and the Fiscal Cliff

by FI Fighter on December 11, 2012

in Stock Investing Thoughts

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.

2012 Taxes

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.

2013 Taxes

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:

http://taxfoundation.org/article/next-years-tax-brackets

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%.

Reaction

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.

Mass Exodus
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:

Long-Term Strategy:
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.

Short-Term News:
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:

Time-Tested Results:
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.

Time Horizon:
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.

Opportunity Knocks:
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.

Summary

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…

 

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{ 26 comments… read them below or add one }

PKNo Gravatar December 11, 2012 at 7:41 am

The worst part: there’s no real comparable history to take a look at to divine knowledge. Under Reagan, dividend top rates went from 20% to 28% in 1986, but we’ve never seen anything like 15% to 40+% (or 0 or 5% to ‘marginal rate’).

But hey, there was a tech bubble last time the capital gains rate and the dividend rate were so different – maybe we can ride tech bubble 2.0! (3.0? Why don’t we count the wave in the 60s/70s?)

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FI FighterNo Gravatar December 11, 2012 at 8:12 pm

PK,

We may very well be entering uncharted territories when it comes to dividend taxation, but the Core Holdings in a well balanced dividend paying portfolio usually consist of the best of the best blue chips that have a history of holding up well in tough economical times. I have no doubts that companies like KO, JNJ, MCD, EMR, etc. will continue to not only pay, but increase their dividends. They’ve survived plenty of storms before, so why start worrying now?

Take care!

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Brick By Brick Investing | MarvinNo Gravatar December 11, 2012 at 10:57 am

Great rational. It’s absolutely ridiculous and makes no sense for the government to tax dividends the way they are but as you point out you are a dividend investor. There may be a mass exodus by the higher income individuals but I would be they stay just where they are for the simple fact that they can’t find the same yields anywhere else in the U.S. Then again they could pull the money out of the stock market and invest in real estate. It is really too early to tell, none the less it’s glad to interact with someone who is on the same page.

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FI FighterNo Gravatar December 11, 2012 at 8:19 pm

Marvin,

Very good point. Even if investors wanted to flee, there aren’t very many other viable income producing alternatives out there. Real estate is a good one, but usually only in a few concentrated regions. It will be interesting to see how things play out. Keep that dry powder ready.

Cheers!

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John S @ Frugal RulesNo Gravatar December 11, 2012 at 11:35 am

You hit on an important point that many investors miss out on because of the craze the media is trying to put us in…don’t run around like a chicken with its head cut off. Yes, if the “Cliff” does happen it might mean the need to make some slight changes but don’t let that change your long term focus.

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FI FighterNo Gravatar December 11, 2012 at 8:22 pm

John,

Yes, as investors, we’ve got to stick to our plan. Usually, a plan is formulated when we are thinking clearly and seeing the big picture. A strategy that is akin to a chicken running around with its head cut off? Yeah, that sounds like a recipe for disaster… or some good noodle soup.

Cheers!

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MartinNo Gravatar December 11, 2012 at 9:30 pm

Amen!

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Dividend MantraNo Gravatar December 11, 2012 at 4:58 pm

FI Fighter,

I haven’t written about this yet, but may do so soon. The Fiscal Cliff simply doesn’t concern me and my long-term goals. I really don’t believe that any significant number of dividend growth companies that I invest in (mostly large-cap blue chip) will actually consider lowering or reducing payouts in an environment that is more along the lines of the historical norm. These companies have been paying out dividends when the tax rates were significantly higher than they are now. The Bush-era tax cuts were never meant to be permanent anyway…so the fact that people are clamoring over this just goes to show you the shortsightedness of people/investors/politicians. People like to project the current into the future instead of being rational about normalcy.

I’m like a robot with a laser focus. I’ve been paying attention to news on the Fiscal Cliff only because it’s difficult not to, but either way you cut it revenue needs to increase, and spending needs to decrease. Whether this happens through negotiations or a self-imposed cliff doesn’t really matter for long-term investors. You may end up paying more in taxes, sure…but I don’t invest to minimize taxes. I invest to maximize my long-term income potential. If I was looking to avoid taxes I’d put my cash under my mattress and quit my job. I, of course, wouldn’t get very far doing that.

Just my take on it. Great article and the charts were really interesting. Imagine having tax rates like they did in the 30′s and 40′s! Yikes.

Best wishes.

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FI FighterNo Gravatar December 11, 2012 at 8:31 pm

DM,

I’m with you. Long-term, the fiscal cliff doesn’t worry me, so, I’m not going to freak out and change my investment strategy just because it’s all over the news right now.

Nonetheless, the market doesn’t care about what rational people think, and will overreact anyway. I do care about market volatility immensely though, because I’m really looking forward to another one of those once-in-a-lifetime buying opportunities. That’s right, I’m greedy, am loading up on cash, and am patiently waiting for something to set off the market. Will the fiscal cliff do it? I sure hope so.

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Jon @ MoneySmartGuidesNo Gravatar December 11, 2012 at 5:01 pm

Good to see you are taking a long term approach to it. With the media hyping the cliff, it makes it seems like whatever happens on January 1, 2013 is the law forever. For all we know, a deal could be struck in February and be retroactive to the start of the year. Or, things could change in a year or two.

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FI FighterNo Gravatar December 12, 2012 at 10:20 pm

Jon,

That’s true, a deal could be reached tomorrow, next week, or next year for all we know. I’m actually a bit surprised the markets haven’t sold off yet, as we enter the final few week of the year. People aren’t freaking out as much as I would have guessed. Maybe common sense is prevailing?

Best wishes!

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Holly@ClubThriftyNo Gravatar December 11, 2012 at 6:53 pm

I cannot wait until the fiscal cliff is resolved in some way so that everyone can move forward making informed decisions. It’s frustrating with so much being up in the air.

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FI FighterNo Gravatar December 12, 2012 at 10:22 pm

Holly,

Yeah, the fiscal cliff is kind of annoying, since it’s an ongoing development. But once this gets resolved, there will probably just be something else to take its place. Back to the Euro-crisis? People always need something to be fearful of, or so it seems.

Take care!

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LeighNo Gravatar December 11, 2012 at 9:01 pm

I think that this fiscal cliff business is definitely a good example of why it’s easier to stick your plan when you just ignore the media.

I have Total International in taxable and sure some years it pays out more in dividends than Total US does, but that’s not really worth paying short-term capital gains to switch for and I really have no way of knowing which one will pay out more in dividends in a given year.

Plus, we never know what will happen with taxes in any given year. I’m pretty likely to gross more than enough more next year that any increase in taxes won’t result in a lower take-home pay, so I’m not really concerned. I love your analysis of the tax brackets though!

P.S. Could you fix your feed so it shows the whole article? I skim Google Reader on my phone often and I only get an excerpt of your feed :(

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MartinNo Gravatar December 11, 2012 at 9:29 pm

Leigh, you are right. The only thing which scares me is possible sell off to lower the value of the stock to make up for the lost yield. Although generally I do not care that much of the value (price) of each individual stock (I rather care of sustainable and growing income), but still I do not like holding losing positions. Another aspect on the other side of the spectrum is, that we will get a great opportunity to buy more cheaper. However in my case the addition will not average the price enough to eliminate sitting in losing position.

Other than that I do not care much. My policy is also to make or have enough dividend income to pay my bills and taxes.

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FI FighterNo Gravatar December 12, 2012 at 10:39 pm

Martin,

Yep, that’s the plan! Enough dividends to pay the bills and taxes. It almost sounds simple enough, doesn’t it?

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FI FighterNo Gravatar December 12, 2012 at 10:26 pm

Leigh,

It’s probably a good idea to hold on to both the total international fund and the total US fund. The small differences in dividends probably aren’t worth the hassle, and besides, it’s smart to diversify.

I hold both and some bonds in my retirement accounts.

p.s. I’ve attempted to fix the feed by playing around with some settings. Thanks for the heads up! I wasn’t aware of this issue. If you would be so kind as to let me know whether or not the issue is fixed… ;)

Take care!

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LeighNo Gravatar December 12, 2012 at 10:56 pm

Looks right now! Thanks so much :D

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FI FighterNo Gravatar December 13, 2012 at 10:49 pm

Great! Glad it works now.

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MartinNo Gravatar December 11, 2012 at 9:23 pm

I do not think that rich people will quit and sell their holdings. There is not too many places to go around the world. The US markets are the largest and most liquid in the world. They may be going to London, or maybe Japan, Frankfurt and that’s about it. I think the most likely scenario will be that they will change their entity. See what’s happening in Europe in Britain and France where they already enacted high taxes on rich (Britain 50%, France 70%). The rich are taking citizenship in Belgium, Holland, Lichtenstein where they get favorable taxing and pay taxes in those countries instead. They still remain invested, but as foreign citizens they pay taxes in their new homes. Others may invest as hedge funds or mutual funds and thus paying taxes as corporations to avoid personal taxes. I knew one person in my town who has been doing it for years this way. According to that he was poor. His company paid for and owned everything.

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FI FighterNo Gravatar December 12, 2012 at 10:37 pm

Martin,

Thanks for the informative reply. That’s very interesting, and I was not aware of these tactics that the rich like to employ. I guess you gotta do what you gotta do, especially when the government won’t stop coming after you. I’m certain there are many other loop holes the rich make good use of ;)

Cheers!

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Dividend Growth Stock InvestingNo Gravatar December 12, 2012 at 1:14 pm

Like you I am sticking to the dividend growth strategy because over the long term I believe it will still prove prosperous. The only concern I have is if some of my companies change their dividend paying philosophy and decide to grow dividends slower or even cut dividends. I’m hoping that with my portfolio only a couple companies will take this route, if any.

Only issue is my dividend growth stocks are held in a taxable account. Currently my portfolio is small enough that I can afford to pay the taxes on dividends out of the salary from my day job. However, I hope my portfolio will continue to grow and eventually I will be forced to use some of the dividend income to pay taxes which means less being reinvested. Over the long run this will amount to quite a bit of money. But 2 things you can’t avoid in life are death and taxes.

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FI FighterNo Gravatar December 12, 2012 at 10:33 pm

DGSI,

I share the same concerns as you do. In the long-term, I’m not worried, but in the short-term it would be a little disappointing to see companies slow down on the dividend growth. Let’s hope most companies don’t elect to go this route.

Yeah, the new tax rates would be somewhat of a burden to an investor with a large taxable portfolio. In a way, it’s a good problem to have. For instance, I’m going to keep building up my portfolio, and paying the taxes, regardless of the rate. If I ever reach the point where the taxes become a huge burden, well, that probably means I’m just getting closer to retirement! So, I probably won’t have much longer to go before I stop working, which will lower my tax rate to the lowest bracket (hopefully a favorable rate at that time). So, in a way, it’s kind of a self-correcting mechanism.

Best wishes!

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JC @ PassiveIncomePursuitNo Gravatar December 13, 2012 at 4:46 am

If rates go up then so be it. It won’t be the end of the world. That’s coming before rates will go up anyways, right? I really wish that there would be a complete overhaul of the system, because it’s ridiculous how much information you have to get to be able to file your taxes. Of course, I don’t think that will happen anytime soon and if anything it’s just going to get more complicated. I’m continuing to be on the lookout for shares in great companies that increase their dividends. We never know what’s going to happen from year to year so it’s just short term issues we have to deal with on our long term investing path.

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FI FighterNo Gravatar December 13, 2012 at 9:48 pm

JC,

haha, yeah the world may indeed end before the fiscal cliff arrives, so why worry? We should probably just cash out now and live it up while we still can.

That’s also my take on the short term news. If it isn’t the fiscal cliff, then it’s Europe again… if it isn’t that, it’ll just be something else. Fear sells. That’s why it’s all over the news. As long-term investors, we just stick to our strategy and keep our eye on the prize. Let’s keep looking for those good deals while everyone else panics and sells.

Take care!

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MikeNo Gravatar December 28, 2012 at 8:27 pm

Where else are the rich going to go? Real estate? Non-income-producing precious metals?

Keep in mind that the tax increase won’t affect foreign investors in US stocks, because they already didn’t qualify for the lower rate, and their rate isn’t scheduled to change.

And US investors won’t be able to hide from the tax increase by moving to foreign stocks. Because a 39.6% or 43+% rate will, in effect, also be charged on foreign dividends (e.g., if a US person at the 39.6% rate pays 25% to the Canadian government for her Canadian dividends, then she will have to pay 14.6% to the US government after the tax credit). So there’s no advantage to going to foreign stocks.

Perhaps some will go to annuities, but the fees (which are charged not on income but on the entire value of the annuity) can easily add up to more than a dividend tax.

On another note, if the companies that paid dividends for 100 years keep paying those dividends, and keep increasing the payout, then a short-term sell-off is your best friend. All it means, after all, is that your stream of future dividends just went on sale.

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