Here's Why The Fiscal Cliff Deal is Great News For Dividend Stocks

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I wish I had a nickel for every scary story I read about dividend stocks and the fiscal cliff over the last four months.

I heard so many, I could probably take the rest of the year off.

Of course, a funny thing happened on the way to this great apocalypse: dividend stocks are not only alive and well, but stronger than ever.

As I wrote a few weeks ago, the Fiscal Cliff fears surrounding income stocks were completely overblown.

And now that a budget agreement has been reached and the tax treatment of dividends is locked in, all of this doom-and-gloom can now be finally put to rest.

With a deal in place, dividends will be taxed as favorably for investors as capital gains. For lower income folks, qualified dividends continue to be taxed at 15%.

It only changes for investors who have met the government's latest definition of "rich."

For those with incomes above $400,000 ($450,000 for a married couple) there is quite a substantial increase in the tax rate on qualified dividends. It rises from 15% to 23.8%, including the 3.8% investment income surcharge in the Obamacare legislation.

However, the capital gains tax in this bracket will rise by the same amount, while interest income will be taxed at 43.4% (39.6% income tax plus the 3.8% Obamacare surcharge.)

That means the relative advantage of qualified dividends over interest income will be preserved, along with the parity between dividend and capital gains tax rates.

So for most dividend investors, very little about their investments has changed.

The difference is that these new rates are permanent - there's no 10-year horizon, as there was with the previous 15% dividend tax rate. So investment planning just got a bit easier.

The bottom line is that with the fiscal cliff deal, there are now three good reasons why dividend stocks are irresistible.

  • First, the yield on prime dividend stocks is higher than on prime bonds, with 10-year Treasuries yielding less than 2%;
  • Second, earnings (and therefore presumably dividends) of industrial companies are protected against a surge in inflation. If inflation suddenly surges to 10% (which it may, with current money-printing policies) the prices of industrial outputs will rise in tandem, and so will corporate earnings. Be careful however; this isn't true of financial companies, whose assets and earnings are mostly expressed in nominal dollars;
  • Third, dividends are taxed as favorably as capital gains, and much more favorably than interest. A 4% dividend is worth 3.05% after-tax to a wealthy investor. To get the same after-tax return from a bond he would have to find a yield of 5.39%.
The only other difficulty is determining whether a particular dividend is qualified.

Since real estate investment trusts (REITs) and Master Limited Partnerships (MLPs) do not pay tax at the corporate level, their dividends do not qualify for the lower 15% tax rate, but suffer tax at ordinary income rates.

Dividends from foreign companies also do not count as "qualified" since the companies have not paid U.S. taxes. That means shares of REITs, MLPs, and companies registered abroad will pay shareholder dividends which are subject to ordinary income tax rates.

My Favorite Dividend Aristocrats

That's why the most attractive dividend-paying stocks in this new environment are the "dividend aristocrats" which have increased their dividends every year for 30 years or more, and whose business is in stable non-financial sectors.

Two of my favorite "aristocrats" include:

Diebold Inc. (NYSE:DBD): This company provides service solutions like ATMs to the financial and other industries. Diebold has increased its dividend every year since 1954 and currently yields 3.7%, standing on a P/E ratio of 11.8%.

Johnson & Johnson (NYSE:JNJ): This healthcare giant has increased its dividend every year since 1962 and currently yields 3.5%. Its trailing P/E is 23 times, but 2013 earnings are expected to improve sharply, giving it a prospective P/E ratio of a much healthier 13 times earnings.

Of course, it is worth noting that investors who buy stocks through retirement or other tax-free funds don't need to worry about any of this tax nonsense.

For them REITs, MLPs and foreign stocks are as attractive as domestic industrials, because their dividends are tax free until withdrawal. Lucky them!

But for the rest of us, or for our taxable portfolios, the "dividend aristocrats" are attractive right now-especially now that we don't have to worry about all of those dire predictions.

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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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