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With election season behind us — and little meaningful change in Washington — investors are now turning their attention back to the looming fiscal cliff.
I can see why!
It’s not clear that either side is really going to budge and if a deal isn’t reached a number of tax rates are automatically going up in 2013 (along with 70+ tax breaks that will expire).
One of the most widely-discussed issues is the tax treatment of dividend payments.
Most investors are currently paying a 15 percent annual tax rate on both capital gains and any qualified dividends they receive. But unless a new deal is reached, that favored tax treatment will revert to ordinary income rates come January 1.
That’s bad enough. What’s worse is that ordinary income rates are ALSO set to rise on January 1 by as much as 4.6 percentage points.
So a taxpayer in the highest bracket could quickly find themselves handing back 39.6 percent of their dividend income rather than just 15 percent!
Oh, and there’s also an additional 3.8 percent Medicare tax that would also go into effect on wealthier Americans’ unearned income — which includes dividends — as well as new limitations on itemized deductions.
Add it all up and the top marginal tax rate on dividends could go all the way up to 44.6 percent!
Already, the market has reacted unfavorably to this possibility — with many higher-yielding categories of stocks taking it on the chin after President Obama’s re-election.
Yet I Do NOT Think Most Investors Should Stress Over
The Issue of Higher Dividend Tax Rates. Here’s Why …
For starters, there is a good chance that the treatment of dividend taxes will be one area where a compromise is reached — especially when it comes to Americans making less than that magical line-in-the-sand figure of $200,000 a year (or $250,000 married filing jointly).
And even if dividend taxes DO jump sharply in 2013, the situation is easily rectified by holding your stocks in tax-sheltered accounts!
For example, the dividend portfolio that I run for my 65-year-old father is safely tucked away in a traditional IRA account. That means Uncle Sam isn’t even getting one single penny of his dividend payments.
Sure, my dad will have to pay taxes on all the money he’s making at some point … but we can control how and when that happens. And with some careful planning, we’ll be able to lessen the overall tax rate he ultimately pays on all of his earnings.
Moreover, if you choose to buy your dividend stocks in a Roth IRA — or you previously rolled your traditional IRA into a Roth as I’ve suggested in the past — then you will NEVER pay taxes on the dividends you’re receiving!
What if your dividend stocks aren’t in a tax shelter? Or getting them into one just isn’t feasible?
Then lawmakers could literally be cutting your income in half for 2013. That’s just another way in which they are outright assaulting anyone who actually depends on the income they receive from their retirement nest eggs!
Yet that still doesn’t mean you should sell your dividend stocks. Here’s why:
First, most dividend stocks continue to yield far more than just about any other relatively safe income investment right now. Heck, I have some recommended stocks that are paying three or four times as much as Treasuries or other fixed-income investments.
In other words, half of that income is STILL more than all the income you’d receive from the alternatives.
Plus, as I’ve pointed out many times before, your dividend payments can grow over time. That is not true of most of the alternatives.
So in the end, we’ll just have to wait and see how this all plays out over the next few months. But I do not recommend making any knee-jerk moves because of all the mainstream media talk regarding dividend taxes.
In fact, I think smart investors — especially those using tax-advantages accounts — should view any further sell-off in blue chip dividend names as a potential buying opportunity.
Best wishes,
Nilus
{ 6 comments }
The unstated conclusion is that higher taxes on dividend yielding stocks should cause the stock price to drop. Even if the dividend remains the same, the loss of value in the stock itself would decrease. What am I missing??
If you’re currently holding the stocks, that’s true. In the worst case scenario, extreme taxes will be passed and it the lower prices will stick for a while. But if your primary goal is safe and growing income streams, the short-term declines are not a major concern. Over time, the share prices will recover. More importantly, if you have additional cash on the sidelines, you can have the best of everything — lower prices getting in, higher immediate yields, and long-term gains as the market climbs. And if a compromise is reached, you will see a very quick snapback …
I cannot understand why my income from working is taxed at 25% plus another 7% for social security and medicare and my dividends are taxed at only 15%!!
It just is not fair to favor the well off which I am!!
Why should dividends be taxed at all? Is certainly not fair to the people who have scrimped and saved so that they can use their money to generate dividends so they will have some income to sustain themselves. The government needs to spend less and let the people decide how to spend their money.
Nilus, thanks for the tip about putting dividend stocks into my Roth. Its a winnner no matter what is eventually decided about the fiscal speed bump.
I do understand what Milius is talking about, and in more simple terms; he is talking about compound interest.
A 401k and a regular IRA are TAXABLE, based on when you take the money out (regardless of income).
I myself am a DRIP investor and am happy that the FED has driven the markets up and down, fortunately the dividends are paid when the “price” is low, therefore I get more shares. But it may become a moot point in the future.
I do have to call out Nilius on one thing. A lot of his commentary depends a heckuva lot on the tax rules not changing. That is way too unpredictable. I do not under estimate or overestimate a politicians stupidity or greed. Any one who can automatically give themselves a pay raise or pay cut is completely unreliable. In any circumstance.
I honestly doubt you will see a voluntary pay cut out of our government. My opinion, they should ALL be paid the standard federal minimum wage, and that they pay FULL taxes on their ‘tips’, if you know what I mean, including their so called PAC.
I do have some constructive criticism too! LOL
Just my 2 cents.
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A ROTH is not taxable( currently), no matter when you take the money out, because you have already paid the taxes on said money (and excluding any future rule changes).
I do have to call him out on the ROTH area though. The ‘Government’ will not long stand this sort of situation. The government is WAY too deep in the hole to allow it to continue. Even if the rules do allow one to save/ reinvest their money through a dividend (so called ‘tax free’), they can change the rules so that this magically disappears. Simply by raising the rates of taxation. This is coming.
The end result is that no matter how you get ANY income will be taxed at a full rate (whatever it is).
This is of course excluding the favored corporations and government employees, and that includes our so called ‘representatives’, who have so far managed to elude the same rules that the average Joe has to live by. And pay for.
Nuff said.