Q&A: The fiscal-cliff tax deal and what it means for dividend-seeking investors
Congress’s action on the tax component of the fiscal-cliff conundrum has provided welcome news for most equity-income investors. We asked Linda Duessel, Federated senior equity-income strategist, for her perspective on the deal, including specific investor impacts and whether dividend stocks—and their future payouts—could be affected.
Q: Can you explain the specifics of the new tax legislation?
The good news is that the law assures no additional tax consequences on dividend income for individuals earning under $200,000 and households earning under $250,000. For individuals earning $400,000 and above and households earning $450,000 and above, the law lifts the tax rate on both dividends and capital gains from 15% to 20%.
On top of this increase is the 3.8% (effective January 1, 2013) on unearned income, including dividends, interest (excluding municipal bond interest), net capital gains, rents and royalties that was embedded in the 2009 Patient Protection and Affordable Health Care Act, unrelated to this legislation. This 3.8% tax applies to individuals earning $200,000 and above and households earning $250,000 and above. As a result, individuals and households earning above $200,000 and $250,000, respectively, will see their tax rate on dividend income and capital gains move to 18.8%. Individuals and households earning above $400,000 and $450,000, respectively, will see their rates on dividends and capital gains move to a total of 23.8%.
Although any tax increase is unwelcome, the legislation avoids an earlier anticipated 43.4% tax rate on investment income for top earners.
Q: Could this tax increase have an impact on dividend-paying stocks?
A substantial portion of dividend-paying investments are held in tax-deferred retirement accounts, lessening the degree to which high-income investors are affected. Also, as noted above, the tax increase on dividends for high earners is substantially less than the 43.4% rate that was widely expected.
But even more significant is the fact that, historically, there has been no correlation between dividend tax rates and dividend-paying stock performance. We can go back to 1913 and see that, for the majority of the time, dividends have been taxed as earned income. It’s also notable that going back to 1926, dividends have been continually tax disadvantaged relative to long-term capital gains. In only two instances were dividends and long-term capital gains taxed at the same levels: in 1988-1990, when they were taxed at 28% and during the current 2003-2012 period when both were taxed at 15%.
Notably, in the period from the mid-1930s through the 1950s, when the marginal tax rate on dividends was as high as 94% and long-term capital gains were taxed at just 25%, high-dividend stocks still outpaced non-dividend stocks that rely on capital appreciation to deliver gains to shareholders. In fact, the dividend tax rate was 50% or higher prior to 1988! Historically, this long-term outperformance gap between high-dividend stocks and non-dividend stocks has generally been greater than the tax savings associated with lower capital gains rates. Keep in mind, when it comes to tax rates on dividends and capital gains for high income earners, this legislation has leveled the playing field.
Q: Will corporations be less inclined to pay or increase dividends given the tax increase?
When launched in 2003, the Bush-era tax cuts were expected to herald in a period where corporate managements would step up their payout ratios to take advantage of the lower dividend tax rates. More companies did, in fact, initiate a dividend after the tax cuts. The companies that had been paying higher dividends all along continued doing so at the same levels. If there is any dividend vulnerability as a result of the new tax legislation, it would be toward those companies without a long history of dividend payouts—Tech companies, for example. The key for dividend-oriented investors then holds true today and that is to search out those companies and sectors that have consistently maintained and increased their commitment to dividend payments.
Q: What about those companies and sectors that have a strong commitment to dividends? Do you expect any change?
Again, history has shown no correlation between tax policy and dividend payouts. In 1998, Eugene Fama and Kenneth French, economists well-known for their work on portfolio theory and analysis, produced a study on dividends. They concluded that companies committed to consistent dividend payouts held the following views: (1) Tax structures are always subject to change so there is no reason to build a dividend policy around them and (2) Shareholders have widely different tax situations; therefore, instead of attempting to target dividend policy to certain income brackets, it is preferable to use dividend payouts to reward all shareholders and to convey management’s confidence regarding the company’s future profitability.
Consider the market’s primary dividend-producing sectors: Consumer Staples, Utilities, Energy, Health Care and Telecomm Services. Many companies within those sectors have paid dividends each year for decades and will likely do so for decades to come. These are the companies that have the managerial ability and inclination to pay a rising income stream to shareholders regardless of market and tax conditions. The course of their dividend policies won’t change because of the next shift in taxation.
Dividends Have Been a Major Component of Total Returns (Click to Enlarge)
Q: Will dividends remain an important source for investment income?
There’s every reason to believe they will. According to the ICI, about 50% of all mutual fund assets are in tax-deferred or tax- advantaged accounts. Those pension and retirement plan accounts won’t be taxed at all until plan members receive the funds as income. Also keep in mind that the tax law related to the Affordable Care Act only applies to individual income above $200,000 and combined income over $250,000 while the 2013 tax increase on investment income applies to individual income above $400,000 and household income over $450,000.
In addition, one significant trend in favor of dividends is the aging of the baby boomers. Some ten thousand of them are expected to turn 65 every day for the next 17 years during a time when pensions have fallen by the wayside, Social Security struggles and Medicare is underfunded by trillions of dollars. According to the Investment Company Institute, more than half of older investors cite current income as their principal reason for investing. With little in the way of meaningful alternatives for investment income, and with growth stocks just too risky as we age, it’s likely that the boomers will continue to turn to dividend-paying stocks for their higher yield potential as they seek to outpace inflation during their years in retirement.
Thank you, Linda.