For income investors, perhaps the greatest anxiety if the U.S. plunges over the fiscal cliff at year-end would be the expiration of the Bush tax cuts — namely, those on dividends.
Unless the Bush-era breaks are extended, taxes on dividends will go from the current 15% rate to something much, much higher — topping out at more than 40% for some investors.
But as MarketWatch’s Jonathan Burton points out, fears that higher taxes on dividends spell bad things for dividend stocks are greatly overblown for a whole bunch of reasons.
For one thing, dividend stocks have performed remarkably well over long periods of time, no matter what the tax rate on payouts. With the exception of some very recent history, taxes on dividends have tracked taxes on ordinary income, which have fluctuated from as much as 90% in the 1950s to 50% in the early 1980s.
And yet, through both heavy tax times and lean, dividend payers outperform non-payers. And, incredibly, companies that paid dividends outperformed non-payers
As Burton notes:
Dividend-paying stocks in the Standard & Poor’s 500-stock index produced a 12.1% annualized total return from the end of 1979 through July of this year, compared with a 10.7% advance for nonpayers, according to research firm S&P Capital IQ …
From the end of 1979 through 2002, before the current parity of dividend and capital-gains tax rates took effect, the dividend stocks outperformed by an even larger margin, gaining 14.4% annually, against an 11.3% return for nondividend shares.
Another reason not to worry too much about higher taxes on dividends: Most folks own stocks through retirements savings plans like 401(k)s and IRAs — which are tax deferred. It doesn’t matter what the tax rate is now or in 2013. All that matters is what your taxes look like when you take those distributions down the road.
And here’s another reason to keep liking those dividend stocks: What alternative do income investors have, anyway? Savings accounts, certificates of deposit, Treasurys? Hah.
There’s little to no income to be found in this market, even after the most muted rates of inflation.
Meanwhile, the dividend yield on the blue-chip Dow Jones Industrial Average is a full percentage point greater than the yield on the benchmark 10-year Treasury note. And at least the stock market has the potential for share-price gains.
Besides, bonds, as sturdy as they’ve been, aren’t exactly cheap after a 30-year bull market — or tax-free, either.
Lastly, sure, the taxes on those dividends could top 40% if the Bush-era cuts expire — but that will apply only to households earning more than $250,000 a year who also happen to have to pay investment taxes.
Most folks aren’t going to fall into that camp.
Yes, taxes on dividends could go up, but then the last 10 years have been the exception, not the norm. And dividends have always been taxed twice — once as corporate earnings and then again as gains — but that’s hardly an argument against them.
Also, let’s not forget that taxes on all capital gains will rise if the U.S. falls off the fiscal cliff, triggering an automatic raft of higher taxes and spending cuts.
That will create much bigger problems that any tax hike on investment gains — if you’re lucky enough to have them.