It's almost certain tax rates on dividend payments will rise, possibly by as much 43.4% for those in upper income brackets.
Some investors could be spared from the dividend tax, depending on the outcome of fiscal cliff negotiations. U.S. President Barack Obama has said he wants to increase the tax on those earning $400,000 or more, while Republicans have suggested raising the tax on those earning $1 million or more.
But even if you're not hit by higher dividend taxes, you could see the prices of stocks you own plunge because of a selloff by investors worried about the higher tax rates.
Two sectors – telecoms and utilities – have been especially hard hit.
Utilities could be the worst-performing sector in 2012, up only 2% through November compared with the Standard & Poor's 500 gain of 15%. Telecoms have slipped 5% to 6% just in the past few months.
Some larger investors in the telecoms sector may have been simply riding momentum and quickly sold out.
Sam Stovall, chief equity strategist at S&P Capital IQ, told CNBC "some of these groups will be and have been beaten up because a lot of these investors were riding the momentum wave for high yielders."
But the selling has been pretty consistent in recent months. From August-November, the top 20% of dividend-paying companies in the S&P 500 underperformed the index by about 3%.
Vadim Zlotnikov, chief market strategist at AllianceBernstein, told the Financial Times, "You can't argue that the threat of higher taxes is not important to investors."
Tax Changes for 2013: The Dividend Hit
High dividend-paying sectors had become particularly attractive to income investors over the past several years as yields have continued to drop in the fixed-income markets. Yields on fixed instruments such as CDs are near zero, thanks to the Federal Reserve's attempts to stimulate the U.S. economy.
Owning dividend-paying stocks has been appealing since 2003 because of tax cuts put into place during the administration of George W. Bush.
Payouts from many such stocks have been taxed at a 15% tax rate instead of at personal tax rates. (Income from bond funds, though, is still taxed at higher personal tax rates.)
Of course, all Bush-era tax cuts would expire tomorrow (Tuesday) if the country fails to avert the fiscal cliff of tax increases and automatic spending cuts.
Some investors worry that even if a deal is reached on the fiscal cliff, the 15% rate on dividends will increase.
Despite that prospect, some investors, especially retirees, won't sell their dividend-paying stocks, as they need them for income because the yield on bonds and other fixed-income instruments is so low.
Some Not So Pessimistic on Dividend Tax Increase
Some analysts say a fiscal cliff deal on dividend taxes likely would increase the taxes by much less than 43.4%.
Analysts from KBW believe that as part of a compromise, taxes on dividends and capital gains would rise from the current 15% to 20%, with an additional 3.8% Obamacare tax on income including that from dividends and capital gains.
Goldman Sachs economists agree with this assessment. They back up their belief by pointing out most Senate Democrats favor a 20% rate on dividends and capital gains.
Whatever the outcome of a compromise on the fiscal cliff, there will be tax changes for dividends. Until there is more certainty on what those tax changes for 2013 will be, the selling will likely continue.
Related Articles and News:
- Money Morning:
Taxmageddon 2013 Hits Dividends Hard – Here's What to Do
- Money Morning:
Taxmageddon 2013: How to Prepare for Looming Tax Law Changes
- The Financial Times:
U.S. investors fret over dividend tax
Fear of 'Fiscal Cliff' Taxes Puts Chill on Dividend Stocks