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.

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