I have structured my portfolio in a way, that I receive regular dividend payments every month, quarter or year. My secondary objective is to generate at least market average total returns.
As an investor, my goal is to generate solid total returns. I achieve this by selecting companies, which will grow earnings, thus afford to pay higher dividends over time and hopefully will be able to sell at higher market prices in the meantime.
I do not worry much about what the tax rates will be in 2013, or over the next four decades. I only worry about selecting great companies.
This might sound like heresy for many investors, who are anxiously hearing about the expiration of the current preferential treatment of dividends in 2012. This could mean that dividends will be taxed as ordinary income, the same way that bonds are taxed today. This could bring a potential 43.6% tax rate on the highest income brackets, if taxes are increased as well.
First, few people are actually making a lot with dividends. Research I have uncovered shows that the average investor in their 60’s does not make more than a few thousand dollars in annual dividend income, or a retired individual, even if dividends are taxed as ordinary income, they would likely not end up paying that much more in taxes.
Of course, if you are a highly compensated lawyer or a company executive officer, chances are that you will be paying that high tax rate. Although no one likes paying taxes, there are few options that investors can choose.
One such option is to put all your money in tax-deferred accounts like IRA’s or ROTH IRA’s. Most investors typically have a large portion of their net worth tied up in IRA’s or 401 (k) plans.
Unfortunately, 401 (k) plans do not offer investors much flexibility in investment options beyond the traditional mutual funds. Utilizing Roth IRA’s would essentially shield investors from paying any taxes during their accumulation period, as well as during their distribution period, as long as they take earnings out after the age of 59 ½ years.
Previously, however, I discussed that there is a $5000 annual limit in saving for retirement in a tax deferred Roth IRA account. Because of this, serious dividend investors would likely have a small amount of their assets in tax deferred accounts.
Many investors also fear the fact that an increase in dividend tax rates would cause corporations to shift their focus from paying dividends to buying back stock. In my experience as a dividend investor, I would say that the companies that have had long histories of paying and even raising distributions to shareholders will continue to do so.
After all, companies like Proctor and Gamble (NYSE:PG) or Coca-Cola (NYSE:KO) have boosted dividends for over 5 decades, while paying dividends for at least one century. The past five decades have been characterized by top marginal taxes on dividends which have been much higher than the proposed tax increase.
In addition, a large portion of the population does have balances in their 401 (k) retirement accounts however. These accounts are mostly invested in mutual funds, who these days own large stakes in America’s largest publicly traded companies. As a result, I do not expect many dividend growth companies to change their payment cultures overnight.
Another reason why investors should not be worried, at least not yet, is the fact that the proposed tax increase in the 2012 budget is not set in stone. The preferential treatment on dividends might still get extended for a few years. Back in 2010, the preferential treatment on dividends was extended for two years. As with most other important decisions, I expect that the outcome related to uncertainties behind dividend tax rates will be resolved in the last minute.