Take Advantage of the Coming Panic

Marc Lichtenfeld By Marc Lichtenfeld, Chief Income Strategist, The Oxford Club

Dividend Investing

I arrived in Washington, D.C. last Wednesday, less than 24 hours after the election. It was all anyone wanted to talk about.

Supporters of President Obama celebrated. Opponents lamented and debates raged on. The election may be over, but there’s still a deep divide among the American population.

Fortunately, the President and House Speaker John Boehner have softened their tones in the aftermath of election season rhetoric. And they appear to understand the need to work together to prevent the fiscal cliff from taking place.

If you’re unfamiliar with the details of the fiscal cliff – unless an agreement is made, on January 1, the Bush-era tax cuts expire. That means income tax rates, taxes on dividends and capital gains, and estate taxes go up. And they’ll rise considerably.

Drastic spending cuts will also take place, which will significantly hurt the economy.

The top income tax rate will increase from 36% to 39.6%. Estate taxes will rise from 35% on amounts above $5 million to 55% above $1 million. Taxes on dividends will climb from 15% to the investor’s ordinary income tax rate.

And that means income investors will see their taxes on dividends more than double if they’re in the top tax bracket.

Obama likely won’t agree to any deal unless taxes increase, in order to generate more revenue. Boehner likely won’t agree to any increase in income tax rates on the top earners. But in this new era of compromise, that doesn’t mean we’re at a stalemate.

How a Compromise Will Affect Your Income

What I believe is the most likely scenario is that Republicans and the President will agree to an increase in the dividend and capital gains tax.

That will hit the wealthiest Americans harder than the middle class, which is what President Obama wants. But it won’t increase the taxes on earnings (either from a job or a business) – a critical component of Republicans’ argument that doing so would hurt job growth.

So, if this deal is made, both sides can claim victory in the spirit of compromise.

Of course, the ones who will be hurt are the investors who rely on dividends to supplement their retirement income or to build wealth via dividend reinvestment.

Because the dividend investor will have less money in his pocket after paying taxes, the logical case is that dividend stocks – which have been white hot in this low interest rate environment – will crater.

The theory makes sense. If investors are going to keep less of their income, they’re going to head for the exits in favor of more attractive investments.

The only problem with that argument is that it’s never happened before during periods of higher taxes on dividends.

In fact, quite the opposite is true…

The Truth Inside the Numbers

During periods of higher dividend taxes, dividend stocks actually performed better than when taxes were lower.

I’m not saying higher taxes caused better returns. I don’t believe there’s necessarily a direct correlation. But just as importantly, there’s no historical correlation between higher dividend taxes and lower returns on dividend stocks.

Many studies have shown this to be true.

I ran a similar analysis comparing 104 Perpetual Dividend Raisers – stocks that raise their dividends every year. In this case, they were companies that had a 25-year or more track record of annual dividend raises. I looked at how they performed during 1985 to 2002, when dividends were taxed at ordinary income levels, and from 2002 to 2011, when they were taxed at 15%.

Here are the annualized results.

Price Appreciation Total Return
Perp. Div. Raisers Fully Taxable 13.7% 15.2%
Perp. Div. Raisers 15% Tax 8.1% 9.8%
S&P 500 Fully Taxable 9.6% 11.1%
S&P 500 15% Tax 4.5% 6.1%

Most importantly, the amount that investors got to keep, even after they paid the higher taxes on their dividends, was still more than when tax rates were lower.

Here’s a table using the above returns net after taxes (assuming the fully taxable rate is 43%, which is what the highest rate will be if we go over the fiscal cliff). If stocks are held over a year, the long-term capital gains tax rate will be 20%, not 43%, so the net after taxes will be higher than the numbers below.

Price Appreciation Net After Taxes Total Return Net After Taxes
Perp. Div. Raisers Fully Taxable 7.8% 8.7%
Perp. Div. Raisers 15% Tax 6.9% 8.3%
S&P 500 Fully Taxable 5.4% 6.3%
S&P 500 15% Tax 3.8% 5.2%

Just to be clear, I’m not suggesting that higher taxes are better for stocks. But I am pointing out that there is no correlation between higher taxes on dividends and poor returns.

Most people don’t realize this.

They naturally assume that a tax increase will tank stocks, and they’ll probably bail on their investments, even the good ones.

But since you’re now armed with the knowledge of how the real world works, you’ll be able to come in like a vulture investor and scoop up their discarded shares at bargain prices.

I suspect we will get a sell-off in the next month or so as investors abandon their holdings. Make a list of quality companies that you’re interested in now so you can jump in and relieve these panicked investors of their safe and rising dividend payers.

Politicians aren’t good for much. But in this case, they may do smart investors a favor and allow them to buy great stocks at better prices and yields.