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.

Join the conversation. Click here to jump to comments…

  1. Jonathan Redecen | September 12, 2012

    The Bush regimes are responsible for many truly dreadful things and the continual warmongering has ruined the USA for many years to come no matter what the taxes. It is too late for a blame game and you will be looking at the 2030s before stabilisation returns if at all. The problem is no longer USA but it is global and there is no quick solution. If you cannot buy then you cannot sell. With USA national debts exceeding $200 trillion it will be nigh impossible to repay and unfortunately the people will have great difficulties surviving whoever is in power.

    • Robert in Canada | September 14, 2012

      Jonathan, you forgot to mention – George Bush also caused Hurricane Katrina and the earth quake in Japan.

      And he is the sole cause of global warming, global cooling, bad weather, and the Ebola virus in Africa.

  2. William Lehman | September 12, 2012

    Thanks for your tax discussion. WOW.

  3. Carole Bye | September 12, 2012

    My income is Social Security only. Not being an investor, none of this is of personal interest to me. Should I become employed again, which I would really like to be, I would like to be informed of all applicable taxes particular to my situation. And, I am going to vote for Obama. No one president can even begin to set in motion all the changes that need to be made in 4 years. 8 years of our current president cannot possibly be any more detrimental than 8 of Mr. Bush.

    • REBECCA.DUNEHEW@GMAIL.COM | September 13, 2012

      I am amazed at your comments, Carol. President Obama will have nothing to lose in a second term since he can't run for office again. His Socialist agenda will take on new life as he makes us , as individuals, bow to the government for everything we need. They are already experimenting with how people can survive in 275 sq. foot living quarters and testing the outrage of limiting the size soda one can buy.

      When you have 30 year old women, whose name I won't mention, wanting the government to pay for her $10 per month birth control, you know that we are crossing a line in the sand. Wake up, Carol, before it's too late.

  4. Mike Sullivan | September 13, 2012

    I don't think the "average American" is overly concerned with having dividend income in excess of $250k. Nor do I think those folks who run major corporations are too concerned about corporate tax rates as they have successfully found many loopholes which in many cases has driven their effective tax rates to 10% or 5% or 0%. At the same time the corp. C levels are receiving rather large salaries and stock options enabling them to offset any personal finacial impact of any individual or joint income tax rate.

    Those of us who have modest incomes, pay our fair share of taxes, and don't ask for nor seek tax loopholes merely want the wealthy to do the same. A real level playing field with real rules for all would shore up a true free market rather nicely.

  5. Matt G | September 13, 2012

    Why does this single concept escape even the most sophisticated investor: THE ONLY (DOUBLE-UNDERLINE "ONLY") REASON TO OWN A STOCK IS TO RECEIVE THE PROFITS OF THE BUSINESS AS DIVIDENDS!!!!

    Why does anybody ever start a business? To make a profit, right? As a stockholder, you are an owner of that business, right? How do owners take profits out of the business? As dividends, right? Ergo, the only reason to own a stock (busubess) is to receive the dividends!

    But then why does the price of a stock rise or fall, you ask? Because the buyer of the stock, as the new owner of the business, expects the profits, and therefore his dividends, to either rise or fall.

    Corporate taxes on monies paid out as dividends amount to double-taxation, if the individual stockholder is also taxed on those dividend payments, and are therefore at least unconscionable, if not technically outright unconstitutional. What will it take to make Congress and the White House, to say nothing of that helicopter pilot in charge of the printing presses, understand and correct this???

    Huzzah, Martin!!! Your plan is really the only trickle-down plan that really will work!

  6. Leo Larsen | September 13, 2012

    Regarding the "Bush" wars, let's remember that most of the Democrats in the Senate voted to go into Iraq, because the public at the time was demanding action after the 911 attacks. It was the sub prime mess that in large part caused our fiscal meltdown. The law was written in the late '70's by Jimmy Carter called the "Community Reinvestment Act", but not really enforced until Bill Clinton was elected President. Obama's Acorn outfit pushed hard for those sub prime loans,and let's not forget Barney Frank who was the point man in the House to stop any reforms of Fannie Mae and Freddie Mac. A New York Times's Pulitzer Prize-winning columnist, Gretchen Morgenson, revealed how the financial meltdown emerged. Her book, "Reckless Endangerment" will explain in detail who did this to us, vs. the usual simplistic "Bush" did it mantra we constantly hear from the finger pointers on the Left. Yes liberals, she writes for the NY Times, not exactly a conservative outfit wouldn't you say? The Movie-"2016:Obama's America" is an eye opener, and will show anyone the true motivation behind his political mindset. Another 4 years of Obama?? You have to be kidding!!

  7. John Doelman | September 14, 2012

    I will vote for Obama only because a vote for the Republican is a vote against the future for my children. We cannot drill our way out of trouble in the energy sector because world demand is rising and the easy stuff is gone. For the last 30 years our entire economy has been based on oil and debt. Oil is running out and debt is only good as long as there is growth. This growth/oil/debt based economy is going to crash and crash badly. The Republicans are doing absolutely NOTHING about this and NEVER have. At least the Democrats talk about it and legislate in that direction. Forget the social issues. They mean nothing. What is important is that we need to overhaul the way we do business and move from a growth economy to sustainability. That means huge investment in whatever follows fossil fuels, even if it is now expensive. We are using 40% more resources on the planet than the planet can create, every year. If you don't think that is a problem, what are you smoking? How do you Romney people think we are going to change that? Do you think denial will change it?

  8. Ed | September 15, 2012

    You may know taxes but not government. It will take more of a change than a new president to repeal Obamacare. The balance in Congress will have to change more favorably for Republicans.

  9. Raymond Finberg | September 18, 2012

    Please uninstall my website I do not enjoy hearing anything more from your bigoted opinions.

    Sincerely

    Ray Finberg

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