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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  1. michael green | January 8, 2013

    could you please clarify your comment Re: MLP'S and the fact that they are ok in retirement accounts. I have heard the opposite, but when I checked with my CPA he thought it was ok also. However it was not a confident positive?? Thanks

  2. H. Craig Bradley | January 8, 2013

    WHAT IS THE "RIGHT" PRICE?

    At current prices, what will be the return on one of these "Aristocrats" if we have a major market decline that is "unexpected" ? ( market corrections or large declines are always unexpected). If you look at the S&P 500 Index from anytime in 2008 to anytime in 2012 you will notice it went nowhere in nominal terms. The market just traded sideways for the last 4 years, with many bull phases and many bear phases, going up, then down in varying amounts. Sector rotation and all that.

    So, for JNJ for example, what would be a good price (one which is likely to be profitable even if the market tanks?) Put it another way: Is JNJ too expensive to build a moat or buffer against an unexpected decline and still be profitable, yielding a good total return in the next 12-24 months? Its real hard to make money in stocks if you pay too much, no matter what the dividend.

  3. Actions françaises avec dividends | January 18, 2013

    I agree that fiscal cliff is a good deal for dividend stocks. It is helpful to increase the share prices. I would like to ask that how it will be helpful for investors after their retirement?

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