The Tax Ax

Investors have enjoyed a prolonged grace period of historically low taxes since 2003, when the maximum rates on ordinary dividends and long-term capital gains were cut. But these lower rates are set to expire at the end of this year, raising many concerns, particularly at the intersection of Wall and Main Streets.

For those who are in the market for long-term gains, higher taxes on dividends could send the prices of those issues tumbling. Generally speaking, a decline would more or less realign the yield with the new tax environment. Meanwhile, there are the camps (including both the well-to-do and not-so-well-to-do) who depend on these payouts as a portion of their income. Naturally, a higher tax bite will mean less change in the pocket for these groups, but it would be especially painful for retirees on fixed income. Bear in mind that seniors make up the largest portion of dividend investors.

In some cases, the increase could be significant, particularly among those issues with the highest payouts. Currently, the highest tax rate for qualified dividends is 15%, but for top earners, it could nearly triple to 39.6%, the same as ordinary income.  Moreover, the rate could go even higher starting in January, 2013, when a 3.8% health care surtax is scheduled to go into effect.

Another consideration is the fact that companies already deal with the double taxation of dividends--first on profits earned, and then again when dividends are paid out to shareholders. Many companies could be tempted to change their dividend policies, choosing instead to plow more back into the company, where it might be seen as a more efficient use of capital.

A House And Senate Divided

With the economy and unemployment situation in less-than-ideal shape, the government has been looking around for ways to trim the budget deficit, or at least slow its rate of growth. Stimulus efforts have been giving a lift to spending, but the country’s tax revenues have been declining. As a result, some view rescinding the Bush era tax cuts as a opportunity at least worth considering.

Up until the recent mid-term elections, with Democrats controlling both the House and Senate, it appeared highly likely that the tax cuts would expire. But with the GOP winning control of Congress, the tide seems to have turned decidedly in favor of keeping at least some of the tax relief in place. Indeed, President Obama has repeatedly indicated that he is in favor of keeping the breaks intact for households earning less than $250,000 annually.

Shelter From The Storm

For a while, investors were pulling out of stocks in droves for the safety and relatively high yields of bonds. But, just as when all the passengers move to one side of a ship, tilting it perilously closer to the water, the other side suddenly becomes much more attractive. With the flood of money into bond funds and the like, yields have fallen considerably, to the point where the benchmark 10-year Treasury note currently pays a tad less than 3.0%, just modestly higher than the Dow Jones Industrial average. Also, with bond yields so low, there’s a lot more room on the upside, meaning that bond values would be prone to falter. This has led more and more investors to consider dividend-paying stocks as an alternative.  However, now the tax issues loom, and so, where should investors turn?

At this point, some may be tempted to move funds into municipal bonds because of their favored tax treatment. However, considering the widespread budget problems facing many cities and states, a high degree of caution would seem warranted.

Meanwhile, Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) would largely not be affected by any tax changes. But their dividends are already fully taxable as ordinary income, so there is no real advantage there. Plus, they come with their own full complement of investment issues.

Basically, for those who don’t want to sweat out any possible surprises in the coming weeks, the best route may be to consider minimizing the tax impact on income-paying investments by making the maximum pretax contribution to 401(k) and IRA accounts. In both cases, dividends wouldn’t be taxed until the time of withdrawal, and then at a (theoretically) lower income rate. Otherwise, the best move may be ….

Staying The Course

All politics aside, it appeared highly unlikely that any major move would be made even prior to the elections. Getting right to the bottom line, both the government and the Fed are using every available tool to increase confidence, borrowing, and spending (for both consumers and businesses) as a way to boost the economy.

One cornerstone of that effort is maintaining a strong stock market. Though never outwardly stated as such, a good part of the Fed’s extended low-rate stance and quantitative easing efforts would appear to be geared toward discouraging savings by keeping interest rates low while aiming for higher inflation. With little return from banks and bonds, people would thus be motivated to invest in stocks or to simply go out and spend.

If this assumption is even partially correct, it would hardly make sense to send a large section of the market reeling with the removal of a tax cut. For one thing, it’s not the sort of development that makes one want to invest. Moreover, the resulting negative wealth effect doesn’t exactly put one in the shopping mood either.  More telling, perhaps, is the fact that no politician on either side of the aisle wants his/her career to be tarnished by having voted for a historically large tax increase.

Putting this all together, it’s a fairly safe bet that households earning less than $250,000 (representing about 98% of the voting public) should come out of this mostly unscathed. And even the upper echelons should be clear for now, at least until the next election cycle in two years. Also on the positive side, clarity on the issue (even if it includes higher rates) could help fuel a general market rally.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.