In recent months, you have undoubtedly read a lot of articles on the looming fiscal cliff. A lot of these articles have mentioned the real possibility of higher capital gains taxes, and suggested ways to take advantage of the panic they are causing among dividend investors (some of which I have even written).
The logic behind the concept is pretty simple… higher taxes on dividends will force investors to look elsewhere where they will be able to avoid paying the slightly higher taxes. While the logic is sound, I feel it is important to point out that dividend stocks are, and will continue to be, a great investment vehicle.
Yes, we are most likely going to see a higher tax on dividends starting next year, but in most cases you are still going to get a higher after tax yield greater than you can find in most fixed income assets.
The Federal Reserve has pushed interest rates near zero, and is expected to continue with this policy at least through next year. Super low interest rates make it almost impossible to earn the same sort of income from fixed income interest as you can earn on dividends, even after you take into consideration the higher tax rate.
I believe the key point is that regardless of what the tax rate winds up being on capital gains, investors should NEVER buy or sell a stock solely on the basis of its dividend. Doing so is a sure fire recipe for failure. If you find a stock that has a nice dividend, has historically raised dividends each year, and has been growing its earnings, then this is the type of stock a solid dividend investor should continue to hold, and even consider buying.
As it currently stands, it appears to be a forgone conclusion that taxes on dividends are going up next year. The only question is how much will they increase. The tax on dividends is currently capped at 15%, but it is scheduled to rise to your ordinary tax bracket, which could mean an increase up to as much as 43.4%, depending on your income level. I believe this is highly doubtful. They will go up, that is for sure, but most likely will wind up somewhere in the range of 20% to 28%.
No one likes to pay higher taxes, myself included, but when it comes to quality dividend stocks, the higher tax is still worthwhile when you take into consideration the positive impact dividend paying stocks can have on your overall portfolio.
History speaks for itself, and if you look all the way back to 1926, you will find that the stock market has had an annualized gain of 9.96%. An important thing to consider is that dividend stocks account for 42% of these gains. The reasoning behind this is simple… companies that can afford to pay regular dividends, and have the ability to increase their dividend payouts each year are going to typically be stronger companies than those who do not.
Of course that is not always the case. There are plenty of solid companies that, for whatever reason, decide not to pay dividends. But on the whole, dividend-paying stocks are more solid investments than their non-paying counterparts.
It is confusing I know. You hear about higher taxes and instantly want to sell your 4.7% yielding Verizon (VZ), or your 4.6% dividend yielding ConocoPhillips (COP), but before you have a fire sale of your dividend paying stocks, take a minute and ask yourself where you are going to put your money to work. It is not always an easy decision.
In conclusion, buying or selling a stock solely on its dividend is never a good idea. It never has been, and it never will be. There are way too many other considerations that you have to take into account when buying a stock, but for sure you do not want to sell good, solid companies right now just to save some money on your taxes next year.
A wise man once told me that paying taxes on a winning trade is better than not paying taxes on a break even trade. This was great advice, and it still holds true today, and will continue to next year regardless of your tax bracket.
Disclaimer: The author of this article has a long position in Verizon (VZ).