Friday, April 30, 2010

The Buzz About Dividend Taxation

An article in Friday's "Wall Street Journal" bemoaned the fact that taxes on dividends could rise dramatically by the end of the year. Here is a quote from the article: "Last week the Senate Budget Committee passed a fiscal 2011 budget resolution that includes an increase in the top tax rate on dividends to 39.6% from the current 15%—a 164% increase. This blows past the 20% rate that President Obama proposed in his 2011 budget and which his economic advisers promised on these pages in 2008." A paragraph later the Journal heaps more pain onto their analysis of dividend taxation: "And that's only for starters. The recent health-care bill includes a 3.8% surcharge on all investment income, including dividends, beginning in 2013. This would nearly triple the top dividend rate to 43.4% in Mr. Obama's four years as President. We suppose the White House would call this another great victory for income equality." While these changes to dividend taxation are not yet the law of the land and the details may change by January 1, 2011, there is now ample evidence that the Bush dividend tax breaks enacted in 2003 will be allowed to die. That means that dividends in 2011 and beyond will be taxed at ordinary income rates. All of the talk about new taxes on dividends has prompted lots of questions about our dividend investment strategy after January 1. Here are a few important points to ponder: The first point is that dividends for most of my 35 years in the investment business have been taxed at ordinary income rates. So the the new taxes are not really new but merely a return to the old way dividends were taxed prior to 2003. The tax breaks of the past 7 years have been a blessing, but with the runaway government deficits this country is experiencing, it is too much to expect that President Obama would hold to his campaign promise of only hiking the tax on dividends to 20%. Because dividends have historically been taxed at ordinary income tax rates, many years ago we created two dividend investment styles. The first is called Cornerstone. Cornerstone currently consists of 30 stocks with an average dividend yield of just over 3% and 5-year average annual dividend growth of near 8.5%. The second is called Capital Builder. Capital Builder currently owns 31 stocks with an average current dividend yield of only 1.9% but the current portfolio has achieved a 5-year average annual dividend growth rate of over 12%. Capital Builder was created specifically for our clients in higher tax brackets. Its current dividend income is much lower than Cornerstone's but it makes up for it with higher dividend growth. Remarkably, however, the total annual rates of return for Cornerstone and Capital Builder have been within a quarter of one percent of each other over the last 15 years. Another important point to remember is that even though dividend taxes may rise, the 43.4% rate quoted in the "Wall Street Journal" only applies to families in the maximum tax bracket, which currently kicks in at about $374,000. There is talk that in the interest of squeezing more out of the "so-called" rich that the maximum tax bracket might be lowered to $250,000. Either way the new higher rates of taxation will only affect a small percentage of the population. Indeed, the current Federal Income Tax Guide shows that for families with taxable income up to about $68,000, the ordinary income tax rate is just under 15%. Taxable income between $68,000 and $137,000 is taxed at 25%. Thus, for many people the tax bite from higher dividend taxes will be very modest. To confuse matters more, the Bush income tax cuts of 2001 will also end on January 1, 2011. If Congress does not act, all income tax brackets will be rising by about 3%. Since President Obama ran on a pledge of no tax hikes for the middle class, we assume that Congress will pass legislation between now and year end that will freeze the Bush 2001 income tax brackets at their current levels, except for people making more than $250,000. Are you confused yet? Not any more than they are in Washington, and that is one of the reasons I have not ventured into the area of dividend taxation until now. It remains very much a moving target, and until the ink is dry I don't foresee that we will recommend many changes to our clients. There are many commentators saying that the reversion to the old form of taxation on dividends will cause American corporations to curtail dividend payments. I believe that line of thinking is completely false. Corporations know that the dividend is an important linchpin between themselves and their shareholders. In addition, dividends are cash money, and in a world of very low interest rates, there are millions of people who count on their dividend income to pay their bills. Corporations who cut dividends or try to sell the idea that they can do better with our money than we can won't get very far. The best examples of this are the major US banks. Almost all of them were forced to cut their dividends over the past 18 months. As their fortunes have improved, they are being besieged with questions about when they are going to reinstate their dividends. Keep an eye on interviews with bank CEOs. In almost every public conversation they are talking about their dividend policies. In summary taxes on dividends are probably going up, but we have been here before, and we have alternative investment styles that can minimize the effect of higher taxes. In addition as it relates to corporations' willingness to pay dividends, IBM just raised their dividend by 18%. IBM can read the headlines about dividend taxation just as well as we all can. If they were going to begin ratcheting down their dividend policy, why would they hike the dividend so sharply? They could have raised their dividend by a nominal amount and no one would have squawked. I believe they hiked the dividend by 18% because they are generating significant free cash flow and they wanted to reward their shareholders for sticking with them during the uncertain times of the last 18 months.