Certified financial planner Wes Moss provides personal finance advice and accessible investment strategies. His guest post appears here weekly.
You’ve probably heard of the “fiscal cliff” our economy could face at year’s end. If Congress doesn’t address several tax issues, $540 billion would be sucked out of our pockets and into government coffers. Congress’ own financial analysts have warned this would almost certainly trigger a recession in 2013.
This could cause other problems for the stock market and investors. A big part of this tax increase – about $220 billion — would come from expiration of the Bush tax cuts, including what amounts to a hike in taxes on capital gains and dividends.
Dividends currently get preferential tax treatment: The highest tax you now pay on a traditional stock dividend is 15 percent — even if you are in the 35 percent income tax bracket. The same policy applies to long-term capital gains tax rates, making dividend-paying stocks and dividend income very attractive.
So what happens if dividend tax rates go up to the same level paid on “ordinary income?” History offers some insight.
A quick look at the performance of dividend-paying equities vs. non-dividend-paying equities — after the dividend tax rate went to the preferential rate of 15 percent in 2003 — shows us something counterintuitive: Dividend-paying equities actually underperformed. This was partially explained by the fact capital gains taxes also went to 15 percent, making non-dividend, high-growth equities even more attractive at the same time.
Current expectations are that while capital gains taxes and dividend taxes may go up, they’ll stay linked and rise together to the same rate. Deviating from this linkage may swing the pendulum one way or the other.
With capital gains taxes likely heading higher in 2013, we probably will see some negative impact on stock prices as 2012 draws to a close. We could see a sell-off as investors look to cash out large gains in case the 15 percent tax rate goes up.
But as an investor I would view a late-year sell-off, fueled by certain tax increases, as a bump in the road — not a brick wall. In fact, if the “fiscal cliff” scenario does push our economy into a recession, we could see large-cap, dividend-paying stocks actually outperform the rest of the market because of their defensive qualities. So, before we even reach such a bump, here’s my reminder to investors: Stay the course.
How do you feel about potentially higher dividend and capital gains taxes? Are you considering selling at least some holdings in case the rate goes up before year-end?
– Wes Moss, for AJC Atlanta Bargain Hunter blog