Is Dividend Investing Done?
Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Of the many impacts that are likely to be felt if the economy is allowed to go over the fiscal cliff, the treatment of dividend income is one concern that seems to have received less than its share of attention. While sequestration and the return of the death tax are without question deeply important issues that must be addressed, the dividend issue has the potential to change the landscape of investing in a fundamentally important way. During a period in which even growth names like Apple (NASDAQ: AAPL) and Cisco Systems (NASDAQ: CSCO) have begun paying dividends to address investor needs, the ramifications of slashing the income available through this avenue should be understood.
The Tax Law
Under the new tax code that will go into effect unless Congress takes proactive steps to prevent it, dividend income will lose its preferential tax treatment in 2013. Where this money is now taxed at a fixed rate of 15%, it will be considered ordinary income and taxed at your effective tax rate. The second barrel of this shotgun blast to your portfolio is the reality that income tax rates will also increase, effectively raising the tax rate on dividends in two ways.
To put this in perspective, a recent report from Reuters explains: “An investor in the top tax bracket, for instance, would pay $4,340 in taxes for every $10,000 in dividend income next year - if the new tax rules take effect, compared with $1,500 under the current rules.” While it is easy to argue that anyone in the top tax bracket can afford the hike, investors at all income levels will be paying significantly more. Furthermore, it is commonly investors in this top bracket that dedicate enough capital to the market to aid the health of those very stocks.
Under the persisting yield conditions, in which U.S. Treasuries continue to offer less than 2%, many companies have used their dividend policy to attract investor attention. While a 2.5% dividend yield for a big industrial name like Caterpillar (NYSE: CAT) is expected, complete industries have become more aggressive with dividends. Bristol-Myers Squibb (NYSE: BMY), which pays 4.2%, Pfizer (NYSE: PFE), which pays 3.6%, and the rest of the big pharma industry have made a big push in this arena.
Even technology companies like Apple have begun including a dividend as a part of their investment profile. While the 1.8% dividend yield offered by Apple shares is not setting a new standard for income investors, the opportunity to get exposure to a growthy name like Apple and still earn a treasury-like yield is significant. In some cases, however, the inclusion of a dividend has been seen as a negative. When Cisco began paying a dividend, many analysts wrote the name directly out of the growth space. Despite the fact that reclassifying Cisco is a mistake, ultimately dividend investing is a balance between yield, dividend sustainability and performance of the underlying security.
The Way Forward
Over the past several years, dividends have begun to play an increasingly important role in investing as yield has been hard to find in any venue. In this spirit, many companies have adjusted their policies in order to attract investment dollars to their respective stocks. The revamping of the tax code is poised to change the way investors view dividend income and the shift is not likely to be stimulative. While the inclusion of dividend income will remain a consideration, if this tax hike is allowed to occur, pure dividend investing will be drastically different. As you consider the fiscal cliff, this should remain a part of your thinking and planning heading into 2013.
Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!