Should You Worry About Dividend Tax Hikes?

Joe is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As you have been hearing all over the news whether financial or network the looming talks about a fiscal cliff have shaken markets lately. Many believe rightly so taxes will go up on many instruments, dividends being one of them. I am a whole hearted believer of buying good dividend paying businesses. The tax increases are threatening the income of those whole depend on these dividends. There are some money managers advising dumping dividend paying stocks but I wholly disagree.

I've looked at the changes in the dividend tax code for top tax brackets since the inception of the tax code to see if there was any correlation to market performance. I put it in a graph below:

<img src="/media/images/user_14630/dividend-tax-code-changes_large.png" />

Up until 1936, dividends were exempt from federal tax, a situation you only find today in for example Municipal bonds and funds. After fully taxing dividends like ordinary income (and market rising in that time) FDR eased up in 1940 in an attempt to boost the economy. Then from 1954 to 1985 a more progressive system was adopted up until 2003 when dividends were cut to a flat 15% rate as part of the so called Bush tax cuts.

There doesn't appear to be a lot of correlation between dividend tax rates and market performance. Raising taxes on dividends did not cause a big lasting sell off within a year after the law was passed. Interesting to note when the rate was cut in 2003, the market ended slightly lower a year later. So I see no compelling reason to sell any of your dividend paying holdings because of the tax threats. Quite frankly, a slowdown in business or change in interest rates are much more of a Market concern than tax rates. Of course, for those who have all their holdings in retirement accounts the tax issue is moot for now. But if you have extra cash outside retirement accounts right now 2 great dividend paying companies that are dirt cheap are Microsoft (NASDAQ: MSFT) and Intel (NASDAQ: INTC). Both are paying an inflation beating 3.4% and 4.5% dividend, respectively, that they have been increasing every year. Both businesses are hated right now which is the perfect time for a Fool to buy or add to existing positions. Intel is down about 25% from its high yet has $14 billion in cash and about half that in debt. It has crushed its main competitor AMD (NYSE: AMD) and generated $8 billion in free cash flow the last year. I don't think that makes a business worth 25% less than it was 7 months ago. Microsoft's sales of Windows 8 has outpaced Windows 7 and the Nokia Lumia mobile phone running Windows is selling out at retailers. Microsoft keeps growing and making tons of money despite internal strife. That's the mark of a great business.

Of course there are strategies one can employ to minimize tax burdens and generate income in your non-retirement accounts. Instead of leaving my money in a pitiful money market account paying an (insult to injury) taxable 0.1%, I like to invest in muni funds. One of my favorites is the Morgan Stanley Insured Municipal Income Trust (NYSE: IIM). Right now it is paying $0.90 per share (paid monthly) which amounts to a 5.2% yield as of this writing. That is a tax free distribution which would amount to about a taxable 8.5% for those in the 35% bracket. This fund holds insured A-rated muni bonds and buying munis in a fund ensures you don't lose a lot of principal should a municipality default on its debt. I like to pick up shares on pullbacks, much like one would do buying high quality stocks.

So I wouldn't fret too much about dividend tax hikes. A wise man once said (or maybe it was a friend of mine) "If you're paying taxes, you're making money". The only way to potentially change tax rates is at the ballot box. If you look into history and compare to current events, you usually find there is nothing new under the sun, except for the iPad mini.

sabatuj has positions in Microsoft, Intel, and the Morgan Stanley Insured Municipal Income Trust. The Motley Fool owns shares of Intel and Microsoft. Motley Fool newsletter services recommend Intel and Microsoft. 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!

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