“What about near-term tax hikes on dividends?” and other important questions …

Although the next Presidential election is still eight months away, a lot of investors are already asking me about possible changes that could come shortly afterward — especially the possibility of higher taxes on dividends starting in 2013. So today, I want to address that issue and also deal with a few other important inquiries on dividends that I’ve been getting lately.

First, the elephant in the room …

“What would happen if taxes go up on dividend payments? Would investors flee the sector? And would companies get stingier?”

As I explained a few weeks ago, most dividend payments currently get favorable tax treatment through this year because of the 2010 Tax Relief Act. That — along with pathetically low interest rates on other investments and plenty of other factors — has encouraged more and more people to flock to my favorite category of investments over the last few years.

But President Obama has certainly not hidden his desire to see dividend taxes go higher, especially for wealthier Americans. In fact, his budget proposal that came out in the middle of February called for the tax rate on dividend income to revert back to the normal income tax rate for upper-income folks — 39.6 percent.

Add in the 3.8 percent tax rate on investment income from the 2009 health-care overhaul passed in 2009, the upshot could be as much as 43.4 percent of someone’s dividend income going back into Uncle Sam’s pockets!

Moreover, unless Congress acts by the end of this year, rates on dividend income for nearly all Americans will at revert to today’s income tax rates, too.

Now before I go any further let me remind you that dividends represent the return of corporate profits to shareholders. In other words, they have typically already been taxed by Uncle Sam at the corporate level. So one could argue that taxing them again — AT ALL — represents a total rip-off.

Of course that’s a much deeper debate best explored in a different column. So for now let’s just assume that tax rates go up on dividends in 2013. What would it mean?

If you listen to some of less-informed mainstream commentators, it will amount to a mass exodus from dividend-paying shares. But I think that’s way off-base for a number of reasons.

First, for average Americans, the rates will not be anywhere near 43.4 percent … and it is relatively easy to avoid any taxation on dividends at all.

Remember, that headline 43.4 percent number only applies to ultra-wealthy investors — most Americans pay far lower income tax rates.

More importantly, you can easily avoid worrying about dividend taxation at all by doing your investing in one of the many tax shelters available to regular Americans — such as IRAs or even 401(k) plans.

It is also quite likely that Congress will extend lower rates for the majority of investors even if they let higher-income investors pay larger rates.

Meanwhile, I don’t need to tell you that the wealthiest Americans have all sorts of ways to avoid taxes through even more advanced strategies.

Second, history doesn’t support the argument that taxation affects corporate dividend policy.

Recent evidence suggests corporate dividend policies are not determined by tax policy. For example, while payments DID jump sharply after the original 2003 legislation lowered dividend tax rates, a study done for the Federal Reserve Board suggested greater corporate profits were the bigger force behind that jump. And the fact that dividends from Real Estate Investment Trusts — which do NOT get favorable treatment — also jumped that year brings home the point.

Third, corporate America is showing no fear of slowing down its dividend payments this time around either, despite the threat.

I have often argued that corporate insiders love paying out dividends precisely because they tend to be large shareholders themselves. Thus, they are effectively handing themselves tax-advantaged payments. So you’d think the threat of higher dividend taxes would reverse that trend — especially since CEOs and board members are the kind of people in the 30-percent-plus tax brackets.

Yet there has been no evidence that they’re concerned. A full 22 S&P 500 member companies INITIATED dividend payments last year, which was a new record. And this year, we’ve seen another five — including Apple’s big announcement.

So the bottom line is that you shouldn’t let the possibility of higher dividend taxes alter your appetite for these powerful wealth-building investments. Instead, you should simply consider using tax shelters more aggressively … and continue to focus on companies with long histories of steadily rising payments that will do well over the long-term.

Now since I mentioned Apple’s dividend announcement, I’d like to answer another big question I’ve been getting …

“Are you going to recommend Apple now that it’s a dividend payer?”

First off, if you happen to be a current shareholder, congratulations — you’ve probably done very well and now you will be getting some regular income to top off your capital appreciation!

Regardless, you shouldn’t expect to see a recommendation of the company from me anytime soon … even if it is now officially a dividend payer.

I have no doubt that the company can continue posting solid results and wowing the world with additional must-have gadgets. I also believe they have done a great job of creating a captive audience that will continue to spend more and more money through the company’s iTunes store.

However, as an investor I’m not willing to take the risk of a slip-up and what such a business hiccup would do to the stock price. Instead, I would prefer to stick to other dividend-paying technology shares out there available at better prices and with far less hype surrounding them.

And that brings me to a final question that might be on your mind …

“It looks like dividend stocks have been underperforming so far this year. What gives?”

It’s true. Last year, my Dividend Superstars list of stocks did ten times better than the S&P 500 … and this year, they’re running behind the broad market indexes so far.

For starters, that’s because the biggest gains this year have been coming from sectors that are not currently major dividend payers — including the aforementioned technology sector (where Apple is really THE story) as well as financials.

Meanwhile if you’re looking at year-to-date performance numbers you have to remember something even more important — a dividend-oriented portfolio is getting a lot of its gains from dividends. What that means is that we have three more quarters of outsized income ahead of us … which is automatically going to narrow the performance gap between the broad market and higher-yielding companies.

Most importantly, those dividend payments are almost certainly coming even if the broad market gives back some of its capital appreciation later in 2012, too!

In other words I see no reason to worry or alter my approach right now — whether because of future tax policies or recent market moves. And I’m confident that I’m going to continue seeing great results by sticking to my longer-term approach.

Best wishes,

Nilus

P.S. I mentioned that financials have been on fire this year. And that’s why the special report on “government bailout contracts” that Tom Essaye and I released a few months ago has been producing absolutely INCREDIBLE profits. We think there’s still a lot more upside ahead and will be releasing the first of our four updates very soon … so now is a great time to secure your own copy. Just click here for all the details now.