Protect Your Money from the Fiscal Cliff Attack on Dividends

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Anyone not living in a cave by now knows about the ominous tax-cut situation – fiscal cliff 2013 – that could be unleashed on the U.S. economy early next year.

That is assuming Congress does nothing, and, let's be honest, doing nothing is one thing in which Congress is truly proficient.

Unfortunately, one of the tax cuts that will sunset should the fiscal cliff become a reality is the dividend tax break that went into effect in President George W. Bush's first term.

This is not an endorsement of one candidate or party over the other. After all, the economy could fall off the fiscal cliff regardless of the outcome of next week's presidential election.

However, there is little refuting the fact that the dividend tax break has been a winner for investors.

The top dividend tax rate is currently 15%, but for the most fortunate among us, that rate could surge to 40% under the fiscal cliff scenario.

In other words, letting the dividend tax cuts expire amounts to a government boondoggle of epic proportions that even Uncle Sam would have a hard time topping.

Here's why.

Fiscal Cliff: The End of Dividends for All?

Simply put, there is empirical evidence to suggest that companies payout more of their profits to shareholders in favorable tax environments.

The top dividend tax rate from 1954 to 1964 was about 80%, according to the Tax Foundation. Back then, payout ratios for U.S. companies averaged a surprising 60%.

But when the top rate was slashed to 35% in the late 1980s, the payout ratio rocked above 80% into the early 1990s.

Of course, there were some outliers along the way. The tech boom that started in the mid-1990s shifted investors' attention away from dividends to high-flying if not unprofitable growth stocks. And as many of us remember, the 2008-2009 financial crisis was a painful time to be an income investor even though the dividend tax rate was the same then as it is today.

Still, the recently favorable tax treatment of dividends has worked in favor of income investors.

Dividend hikes totaled $50.2 billion in 2011, an 89.2% jump over the $26.5 billion seen in 2010, according to Standard & Poor's. In August of this year, a then monthly record $34 billion in dividends were paid.

From 2003 to 2011, individual investors saved $314 billion due to the dividend tax cuts and another $44 billion in savings is expected this year, according to S&P.

That's why a significant dividend tax increase is bad news for everyone from Warren Buffett to Joe Six-Pack.

Protect Against the Fiscal Cliff Dividend Demise

Assuming the worst, there are still a couple of ways for investors to generate income even in a post-fiscal cliff world.

Those options extend beyond the predictable calls for loading up on richly valued MLPs and REITs simply because those firms are required by law to deliver a massive chunk of their profits to shareholders in the form of dividends.

One asset class to consider is municipal bonds, but there is a caveat and it is an important one. In its infinite wisdom, Congress is looking for revenue-generating ideas. One idea, and no one should deem it "good," is eliminating tax-exempt status for interest paid to municipal bond holders.

This issue is separate from the dividend tax and if Congress knew, as Morgan Stanley tells us, that 70% of muni bond holders are individual investors, then there would be no entertaining this flawed idea. Not to mention, the elimination of the tax break on muni bond interest would all but turn off a primary funding stream for already cash-strapped states and cities.

All that said, if the tax status of muni bonds stays the same, the low volatility of this asset coupled with decent yields and, in many cases, monthly dividends, makes these bonds a compelling way to fight the fiscal cliff.

For those with a desire for more adventure, foreign stocks are worth a look.

Those that have owned American depositary receipts in the past know that the net dividend is subject to all the same U.S. tax obligations as a payout earned from an American firm. However, many countries withhold taxes on dividends paid, meaning investors here can claim that withholding as a deduction.

As for dividends, here's to hoping the fiscal cliff remains a buzz phrase and does not become reality.

And good luck to those members of Congress that do not fight to stave off the fiscal cliff. They will likely be looking for new employment.

[Do you agree Congress is a huge part of the problem in Washington? If so, check out this article on why America should fire Congress.]

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  1. H. Craig Bradley | November 1, 2012

    THE PROBLEM OF THE 47%

    The composition of the voters has changed quite a bit since 2000. Traditionally, voters were apt to be citizens and own a home or have a tax paying job. Not anymore. The issue of "voter supression" has recently become the subject of Obama campaign ads.

    Voters had to vote in person at the local precinct at one time. Usually, you had to sign-in and present a photo I.D. ( usually a state driver's license). Under this traditional system, voters could not commit voter fraud. Ineligible voters could not vote. Then came Motor-Voter laws and most recently, internet voter registration in Calif. Now, anyone can vote. Fraud is a given.

    The problem for Federal tax rules governing dividend rates and income tax rates involves participation. Many voters do not own stocks and do not collect dividends. They may not even own a house or condo. So, they don't care what the tax is, especially if it is against "rich people". However, many voters do collect a government entitlement which they want to continue. So, Republican conservatives are not going to get the vote of half the population (47%). Too bad for investors, who have become the minority of total voters in recent years.

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