We’re five days into President Biden’s term, and there are no tax increases yet.
I’m being snarky.
During the campaign, Biden said he would propose raising taxes on corporations and on the highest earners – though it’s hard to imagine a tax increase while the economy is still hobbling.
But anyone born before Sunday (yesterday) knows that tax increases usually are not limited in scope.
As of this moment, the president has said that only individuals making more than $400,000 a year will see their taxes raised to 39.6%. Taxpayers making more than $1 million will have their dividends and long-term capital gains taxed at their ordinary income tax rate, which would be the new 39.6%.
Corporations would also see their tax rate increase to 28% from 21%.
Keep in mind, these are just campaign proposals at this point. There’s a long way to go, including having these tax increases passed in Congress, before they go into effect.
But if we assume for a minute that these tax increases will be implemented, let’s talk about what it means for your investments, specifically your dividend stocks…
Unless you’re in the top 0.35% of taxpayers, your taxes on dividends and capital gains won’t increase under the current proposal. So there is no immediate action that needs to be taken.
For those making more than $1 million per year, it would be a good idea to work with your tax professional on ways to better protect your income.
Many investors keep their higher-tax investments (like bonds) in a tax-deferred account while holding their lower-tax dividend stocks in a taxable account.
Bond interest is currently taxed at ordinary income tax rates, while dividends are taxed at 15% to 23.9% for the highest earners.
Should dividends and capital gains be raised to the ordinary income tax rate, there will be no difference in how stocks and bonds are taxed. So it may make sense, particularly if you’re reinvesting the income, to hold the dividend payers in a tax-deferred account.
With a higher tax rate on dividends for the wealthy, CEOs and board members (who tend to be very high earners) may have more incentive to use excess cash to buy back shares rather than pay a dividend that is taxable to them at nearly 40%.
I hate that idea.
Companies have a long history of buying back shares at the wrong time (when their stocks are at high valuations). Meanwhile, few companies were repurchasing shares in 2008 and 2009 or in the second quarter of last year.
Studies show that companies typically wait until their stock prices are high to buy their shares back, which is not a good use of capital.
If there is excess cash, pay it to shareholders in a dividend. Let them decide whether the stock is still a good buy.
And with corporate free cash flow forecast to rise 29% in 2021, companies will have lots of extra cash.
Now for Something Special…
Don’t be surprised if you see special dividends in 2021.
Companies with excess cash will occasionally pay a special dividend in addition to their regular one.
For example, Costco (Nasdaq: COST) has paid a special dividend three times in the past five years, including a $10 per share special dividend in December.
If it appears that tax rates will increase on dividends next year, I suspect a lot of companies will distribute cash to shareholders in the form of a special dividend.
Lastly, I have predicted that the next few years will see higher inflation than most people are expecting. The Federal Reserve has stated that it is going to allow inflation to rise more than usual before it taps on the brakes by raising interest rates.
So owning Perpetual Dividend Raisers – companies that raise their dividends every year – will become more vital to maintaining and increasing your buying power.
Owning a stock with a 3% yield and a dividend that doesn’t budge will erode your buying power after just two years of what is currently historically low inflation.
If we return to the average inflation rate of 3.1%, your 3% yield means you can buy fewer goods and services next year than you could this year.
However, if you own a stock that grows its dividend by 8% or 10% per year, you are actually increasing the buying power of that dividend over time.
And if you reinvest the dividend, compounding goes into overdrive when the company boosts the payout every year.
There will likely be some important changes on tax and economic policy down the road. I don’t expect anything drastic in 2021. But you should be thinking about the moves to make now so that when they happen, you’re not left scrambling, trying to better protect your money.