7:05PM EST November 8. 2012 - Most investors have a private chamber of horrors they peek into from time to time, typically after steep drops in the Dow Jones industrial average. In the Pit of Pre-Announcements, managements shriek their excuses for poor earnings. Open Dr. Calgari's Cabinet of 8-K Filings, and you'll gaze into a soulless pool of material events that send your stocks plummeting.
For most investors, however, it's the small, quiet room stacked with tax forms that inspires the most terror. And, at least at the moment, some of those fears of higher taxation are entirely justified. The question: Are potentially higher taxes on dividends a good reason for selling stocks? Probably not -- but if investors panic, they could become bargains.
When legislators first enacted the Bush tax cuts in 2000, they thought they had buried the possibility of higher taxes. But the law had a hideous flaw: Without further legislative action, the old, higher tax rates would rise from the dead after 10 years. The legislation was written that way to avoid a Senate rule designed to block legislation that would significantly add to the federal deficit beyond 10 years.
DIVIDENDS: Fiscal cliff spurs early payment
Congress extended the tax cuts in 2010 for two years. Those two years end Dec. 31, and if the lame-duck session does nothing to extend them again, the old tax rates will be reanimated on Jan. 1. Although there are many tax changes that will happen on Jan. 1, we're going to focus on these:
• Maximum taxes on capital gains — the profit when an investment is sold —
will rise to 20% from 15% in the 2013 tax year.
• Taxes on dividends will rise to your current tax rate, up from a maximum 15%.
• The top income tax rate will rise to 39.6%, the top rate during the Clinton era, from 35% now.
On a simple mathematical basis, higher taxes on a dividend argue for a lower price. Let's consider the interesting yet fictional company Wholy Moly, a company whose only line of business is mining molybdenum. The stock sells for $10 a share and pays 30 cents in dividends a year. You own 1,000 shares, or $10,000 of the stock, so your annual dividend is $300.
We talk about dividends in terms of yield: The payout divided by the stock's price. The current yield on your 1,000 shares of stock is 3% — $300 divided by $10,000.
Under current law, a person in the 35% tax bracket would owe 15%, or $45, in taxes on a $300 dividend payout. Your after-tax dividend payment would be $255, and your after-tax dividend yield would be 2.55%.
If Congress allows the Bush tax cuts to expire, the tax on a $300 payout would soar to $118.80, leaving you with $181.20. Your after-tax yield would plunge to 1.81%.
Your after-tax yield could return to its current level in two ways. The first is if Wholy Moly, feeling your pain, raised its dividend enough to get the yield back up. This event is nearly as unlikely as the company itself. "Companies take the dividend rate very seriously," says Neel Kashkari, former assistant secretary to the Treasury and now head of global equities at Pimco. "The worst thing they can do is promise a dividend and then have to reduce it."
All other things being equal, the most likely way to increase the yield is to reduce the stock's price. Given that dividend-paying stocks have been popular lately, the price reduction in dividend-paying stocks could be substantial. Suppose you wanted your 1,000 shares of Wholy Moly to yield 2.55% after taxes again. If the after-tax dividend were $181.20, you'd have to drop the price to $7.11 — a 29% drop — to equal a 2.55% after-tax yield.
However, the relationship between taxes and dividend yield isn't quite as neat as this, says Dan Wiener, publisher of The Independent Adviser for Vanguard Investors, a newsletter. For one thing, many people own dividend-paying stocks in tax-deferred accounts, such as IRAs or pension plans. Dividend tax rates don't matter to them, at least at the moment.
"Some people would rather see regular income than sell appreciated stock," Wiener says. After all, selling a dividend-paying stock would simply trigger capital gains taxes on your profits.
Kashkari suggests that foreign dividend-paying stocks are likely to take a smaller hit from any change in tax laws, because most owners of those stocks don't pay U.S. taxes. For most investors, that means investing through a mutual fund. PowerShares International Dividend Achievers (PID) is one consideration: It yields 3.16%, according to Morningstar, and invests in stocks of companies with a consistent record of raising dividends.
Mutual fund investors need to be careful about looking for dividends through funds, however: Typically, the fund takes its expenses from dividends. If you're an income investor, you might be better served by waiting until Congress resolves tax issues before buying dividend-paying stocks. If tax rates do rise, you'll at least be able to get your shares more cheaply — and avoid watching the market do terrible, horrible things to your investment.
Source: http://www.news.theusalinks.com/2012/11/08/investing-will-tax-hikes-hurt-dividend-stocks/
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