Five Moves for a Dividend Tax Hike

This article published with permission from InvestmentU.com.

Like a lot of kids, when I was little, I was afraid of monsters under the bed.

Fortunately, I quickly realized that there were in fact no monsters and my fears shifted to what would happen when my mom realized I hadn’t cleaned up my room after she asked me for the umpteenth time.

Just like the national media that preys on your fears, there are a lot of bloggers and financial writers who are trying to scare you into freaking out over the looming dividend tax increases.

Among the most commonly used scare tactics is scaring investors into believing that a higher tax rate means their dividend stocks will tank.

Perhaps the initial knee-jerk reaction will be to send those stocks lower. But as I’ve been shouting from the rooftops lately and in the national media, there is no correlation whatsoever between higher taxes and lower returns in the stock market, and particularly dividend-paying stocks.

If anything, what we might see is lower dividend growth next year by companies that have announced special dividends or pushed their dividend raises up in order to get them in under the 2012 tax year and the 15% rate.

It remains to be seen whether the agreement between the president and lawmakers will return dividend taxes to ordinary income rates or a simple flat rate. My prediction is dividend taxes will be capped at 30%. We should have more information over the coming weeks.

The other scare tactic by media and bloggers is constantly mentioning the 43.4% potential top tax rate on dividends. As I discussed in last week’s column, where I pretended to interview the president, even if the rate goes up to 43.4%, it’s not an automatic 43.4% haircut to an investor’s take-home amount.

The top tax rate doesn’t kick in until any amount over $250,000 for a married couple. In other words, if your adjusted gross income, including dividends, was $250,100, you’d only pay 43.4% on the $100 — not the entire $250,100.

Still, any increase in the tax rate stings. And in cases where retirees live off of their dividend income, it may impact their quality of life…

Making moves in 2013

Whatever the new rate is, I’m fairly certain it will be higher than the current 15%. As much as we hate it, we’ll have to face it. But there are two moves you should make and three you absolutely shouldn’t as we head into the New Year and new tax rate on dividends:

Move 1

If possible, put your dividend-paying stocks (and other income-producing investments) in an individual retirement account (IRA). That will allow the dividends to accumulate tax-deferred.

Move 2

Talk to your tax advisor. There may be ways of setting up trusts, accounts in your children’s names, or other maneuvers you can make to lessen the tax bite. But do that soon — before Dec. 31.

Move 3

Don’t panic. Don’t sell stocks simply because you think you’ll owe more taxes on them. While you want to set up your investments for maximum tax efficiency, you shouldn’t make buy or sell decisions based on taxes. If you think a stock is a good investment, hang on to it. If not, sell it, but don’t let taxes be the overriding factor in your decision.

Move 4

Don’t chase yield. You’re going to keep less cash from your dividends in 2013 due to higher taxes. Don’t try to replace the lost money by simply purchasing higher yielding stocks. That’s a recipe for disaster. Higher yields usually mean higher risk.

Move 5

Don’t fall for gimmicks. Lots of companies are paying special dividends this month. That’s like going to buy a used car and falling in love with it because of the paint job. You buy the car because the engine is in good shape, it’s a comfortable ride and it’s a good value for the money.

With dividend-paying stocks, buy because it has a solid yield, but even more importantly, buy because it has a track record of dividend growth and generates enough cash to continue growing the dividend going forward.

If these companies had so much cash before that they can, all of a sudden, part with it in the form of a special dividend, why weren’t they more shareholder friendly over the past few years? They should have paid a solid dividend and boosted it every year if they had the funds.

Stocks are going to do what they have always done over the long term, and that’s provide a good return for investors — regardless of war, taxes, assassinations, financial crises, etc. And considering that taxes may, at worst, return to near historical averages, stocks, particularly dividend growers, should continue to outperform nearly every other asset category.

Don’t let the monsters under the bed convince you otherwise.

Marc Lichtenfeld is the Senior Analyst at InvestmentU.com.See more articles by Marc here.