Certified financial planner Wes Moss provides personal finance advice and accessible investment strategies. His guest post appears here weekly.
I’m a big believer in income investing, a strategy that includes buying stocks that pay dividends.
How will such stocks be affected if the dividend tax rate goes up in the new year?
First, some history. In 2003 Congress lowered the dividend tax rate, which was supposed to be great for dividend-paying stocks. So why didn’t dividend stocks surge past everything else? Because Congress simultaneously lowered the capital gains rate, which made investing in small-caps stocks, which typically don’t pay dividends, more attractive to investors seeking capital appreciation.
This, in part, lowered the demand for dividend-paying stocks, even at their new lower tax rate.
This time around we could see the opposite happen. Yes, higher dividend tax rates would seemingly hurt large-cap dividend-paying stocks. But if capital gain taxes also go up, there could be less demand for the same small-cap “growers” that did so well after 2003 — and potentially more desire for large-cap dividend payers.
Larger companies may be better suited to endure a slower-growth economy, which we didn’t have in 2003. They generally have better access to capital and stronger balance sheets. Today’s near-zero interest rates on money markets and CDs leave investors searching for income/yield elsewhere — something more readily available from these same large dividend-paying stocks.
The thing I’ve heard the most from investors is the belief the tax rate on their dividends is going from 15 percent to 43.4 percent. But here’s the deal: Your dividend taxes won’t automatically jump to 43.4 percent — though they will potentially jump to whatever your personal highest marginal tax bracket is. If that number for you is 20 percent, then that’s your new dividend tax rate.
So who will pay more?
Those who own dividend-paying stocks outside of retirement accounts will pay more if their highest marginal tax rate exceeds 15 percent. Remember, retirement accounts such as IRAs, 401(k)s and 403(b)s are sheltered from investment taxes.
Here’s another way to look at it: About half of all stocks are held outside of qualified — retirement-like — accounts. We also can deduct from tax records that only about a quarter of taxpayers pay above a 20 percent federal tax rate. What this means is 85-90 percent of all stock holdings should escape much higher rates.
If you do end up in one of the two top tax brackets, your taxes will probably go up in some way, shape or form. And if you own a stock that has enjoyed a huge dollar gain, it might make sense to sell those shares before your capital gains tax rises from the current 15 percent to the 23.8 percent level being discussed.
If a significant number of people make that move, it could create a buying opportunity in the market.
What’s your forecast? If you hold dividend-paying stocks, what are your plans?
– Wes Moss, for AJC Atlanta Bargain Hunter blog