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Dividend Tax Hike: Impact on Stocks Might be Different Than You Think

Before the end of this year Congress has to make a decision about how dividends are taxed. If Congress lets current law expire, the current maximum 15% tax rate on qualified dividends will vanish and dividends will revert to being taxed at ordinary income tax rates. Right now that’s 35%, but current individual income tax rates also expire at the end of 2012; we won’t know until the lame duck session in Congress what rates will look like in 2013.

So it stands to reason that if dividend stocks are suddenly taxed at a higher rate, their allure will fall, sending the value of the stocks down. That wouldn’t exactly be great news for dividend stalwarts such as General Mills (GIS), Exxon-Mobil (XOM) and Coca-Cola (KO), right?

GIS Dividend Chart

GIS Dividend data by YCharts

Not so fast, says James Morrow, manager of the $8.5 billion Fidelity Equity Income fund. He and a few Fidelity colleagues who traffic in dividend payers took a deep dive into the topic and emerged with the opinion that a boost in the tax rate will not sink dividend stocks.

“Higher taxes are never good—but in my view, the possibility that rates will increase doesn’t alter the fundamental case for dividend-paying stocks.,” wrote Morrow.

According to the money managers, the fact that more than one-third of U.S. stocks are held in tax-advantaged accounts such as IRAs and 401(k)s, mitigates the impact of any change in tax law; as long as your dividends are taxed into those tax-deferred accounts you don’t have to worry about the tax rate. Moreover, the money managers note that most of the dividend income earned in the U.S. goes to the 1%, and, well, they are so stinking rich, their dividend income is less than 5% of their total income. So though they may gripe a bit at a higher dividend tax rate, its impact is likely not much more than a rounding error in their annual net worth.

Morrow also pointed out an interesting counter-argument: a change in the dividend tax rate could be part of a more comprehensive tax bill that could address the taxation of how U.S. corporations are taxed for earnings overseas. Right now, the likes of Cisco (CSCO) and Apple (AAPL) keep boatloads of their earnings overseas rather than bring ‘em back and pay a tax rate as high as 35%. If that rate was reduced-to get more of that money back to work in the U.S. economy -- the theory is that the cash rich companies would turn around and boost their dividend payouts. (Note: U.S. corporations can’t use cash held outside the country to pay out dividends.)

For the other 99%, though, it’s important to understand the more fundamental risk for dividend stocks. Namely, no matter how high the yield, and no matter how healthy the payout ratio, dividend payers are not immune to market drops.

Here’s how a few popular dividend stocks performed during the brunt of the financial-crisis sell-off, compared to the performance of the Vanguard Growth ETF (VUG). You got a relative victory, wrapped in absolute losses as seen in this stock chart.

KO Chart

KO data by YCharts

The SPDR S&P Dividend ETF (SDY), comprised of high yielders that have a long history of maintaining or growing their dividend -- think Walgreen’s (WAG), Sysco (SYY) and Consolidated Edison (ED) -- wasn’t exactly a lifesaver when markets sank in 2011.

SDY Chart

SDY data by YCharts

That’s not a knock against dividend stocks. Just a reminder for frustrated bond investors considering a shift into dividend stocks, given the higher yields, that they will be buying a whole lot more volatility.

Over the longer-term, that move can pay off. The total return (yield plus price change) of the dividend ETF has handily beaten the benchmark S&P 500.

SDY Total Return Price Chart

SDY Total Return Price data by YCharts

Just beware that any intermittent market volatility could tax your nerves.

Carla Fried is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.

Read more articles about: Investing Ideas  

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