Why Dividend Investors Should Worry About an Obama Victory

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I don't have to tell you there is a lot at stake for dividend investors in November.

In fact, an Obama victory could hit income investors with something of a double whammy.

You see, for dividend investors it isn't simply just a matter of higher tax rates, the changes President Obama has in mind may result in fewer dividends paid altogether.

You can chalk it up to the law of unintended consequences.

Let me explain.

Thanks to the Bush tax cuts of 2003, dividends are currently taxed at 15% to individual investors.

The rationale for the change was that dividends are paid from income that has already been taxed once at the corporate level. It means the total top federal tax rate on dividends, including the 35% corporate tax, is currently 45% (the net received is 85% of 65%).

Even with the tax break, that's still higher than the top 35% rate of personal income tax.

That's bad enough, but even if the Bush tax cuts are renewed before the "fiscal cliff" strikes at the end the year, investment income will suffer an additional 3.8% tax starting on January 1 to pay for Obamacare.

That means the total tax on dividends could jump to a whopping 47.2%.

Of course, if your total income is less than $250,000 for a married couple you will not pay this, so your total dividend tax rate will remain 45%.

But again, that's just the status quo, which is no big win, either.

The truth is that in a sensible tax system, dividends would be deductible from corporate income for tax purposes, and then taxed at the full individual rate.

This would put dividend on the same footing as interest, eliminating the corporate subsidy for leverage.

It would also eliminate most corporate tax shelters, since shareholders would demand that management not enter into tax shelters that cost money, when they could simply pay the money to them as dividends.

This isn't some wild Ayn Rand fantasy, either.

It's essentially the system that has been used in Britain since 1973. However, regrettably, neither party is proposing it here.

An Obama Win Means Even Higher Taxes

What we do know is that if Republican Mitt Romney is elected, the dividend tax rate for individuals will probably stay at 15%.

In addition, Romney plans to cut the corporate tax rate to 25%. Since he plans to repeal Obamacare, the chances are its 3.8% surtax will disappear also.

If Romney is successful, that would take the dividend tax rate down to 36.2%, similar to the top individual income tax rate.

Of course, that's the "best case" scenario. Still, at worst the total dividend tax rate should stay around the current 45% level.

Meanwhile, if President Obama is re-elected, he has pledged to reduce the corporate tax rate to 28%. That's the good news.

The bad news is that he has pledged to reverse the 2011 cut in individual tax rates, make the top tax rate 39.6%, and eliminate the preference for dividends.

So adding in the Obamacare 3.8% surtax, the total tax rate on dividends would rise to 59.2% if he cuts the corporate tax rate or 63.2% if he doesn't.

That's a very substantial difference than what Romney is proposing.

The Double Whammy For Dividend Investors

But as I said earlier, thanks to the law of unintended consequences there is more to this story than tax rate differences.

That's because corporate management is largely paid today through stock options. It means they really don't like dividends to begin with since they reduce the share price when they are paid, and hence reduce the value of management's options.

Instead, management prefers share repurchases, which tend to increase the share price, along with the value of their options.

Here's the rub for dividend investors...

A big increase in dividend taxation will allow management to decide that dividends are "tax inefficient" and cut or eliminate them.

It's just another part of a larger and ongoing trend.

You see, dividends have been in long-term decline as a percentage of earnings, from about 56% in the 1960s for the Standard and Poor's 500 companies to about 32% in the 2000s, though they rebounded somewhat after the 2003 tax change.

Faced with even higher taxes, you can bet that management will take the opportunity to reduce them even further. Our after-tax dividend income will thus suffer a double whammy from an Obama victory, from the increase in tax and a reduction in dividends.

Of course, there is nothing we can do about the increase in the dividend tax, if it occurs.

However, we can at least eliminate the dividend reduction effect by investing in real estate investment trusts or resource master limited partnerships.

These entities are forced to pay out 90% of their income in dividends, in return for which they suffer no corporate tax. So by investing in REITs and MLPs we achieve two things.

First, by eliminating the corporate income tax we reduce the total dividend tax to our individual tax rate. Second, it leaves corporate managements grinding their teeth in frustration, because the law won't allow them to cut our dividends-even though they may want to!

You'll have to admit, zapping the taxman and greedy corporate management with one investment can't be all that bad!

In the meantime, the fate of our dividends is in the hands of the voters.

About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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