There is a lot of focus on dividend tax increases lately. I am a dividend growth investor, so it is an important subject to me. I decided to take a rough cut at what the impact will be on me and my wife if dividend taxes are raised.
This exercise requires some assumptions, as the extent of any dividend increase is currently unknown, being subject to political negotiations. In my assumptions, I will make harsher projections than I actually think will happen, in order to be conservative. My first assumption is that our effective tax rate on dividends will double in 2013.
In calculating investment returns, I keep taxes off to the side. I have always done this. I consider taxes to be an expense of living, just like the gas bill and dinners out. So we have an income budget and an expense budget. Taxes are in the latter.
We maintain a balanced budget, meaning that we do not run a deficit. Income equals expenses. To protect my privacy, I am going to use numbers that are proportional to our actual situation. I am also going to present a higher proportion of dividend income than we actually get on the income side, to make the outcome more dire than it is likely to be.
On the income side, our budget was $80,000 in 2011, the last year for which I have completed tax returns. Let's say that was made up of $40,000 dividend income and $40,000 from other sources (pension and Social Security). In 2012, our income figures to be 82,800. That reflects the fixed pension and SS payments plus 7% increase in dividends. Looking ahead, our income in 2013 figures to be $85,800, reflecting another 7% increase in our dividends next year. (I am ignoring the small increase in SS.) The 7% increase in dividend income is actually less than we usually get, another conservative projection.
On the expense side, last year we paid $8800 in federal income tax, giving us an effective tax rate of 11% on our $80,000 income. (Everybody's effective tax rate is unique, because of the various accounts in which investments are held, deductions, credits, etc.) Without going back and precisely deconstructing our tax return, I will assume that the taxes on dividends made half of the total taxes, or $4400, meaning that we had an effective tax rate on dividends of 11% also. That's the rate that I will double.
Jumping ahead to 2013, my projection of $85,800 in total income consists of $45,800 from dividends and $40,000 from other sources. If we had an 11% effective federal income tax rate on that total income, our tax bill would be about $9440. But we need to account for doubling the tax rate on the dividend portion of our income from 11% to 22%. Doing the math, this means that the tax on the dividend income ($45,800) would jump to $10,076 from $5038. That is a difference of $5038.
How should that be regarded? It is definitely a pinch. But here is my perspective. With a total income of $85,800, the tax increase represents less than 6% of our total budget. That is less scary than horribilizing about the maximum marginal tax rate on dividends doubling.
We will have a monthly budget in 2013 of $7150. The tax increase under my assumptions means that we will have a tax increase of about $420 per month or about $97 per week in our expense budget. I don't mean to be cavalier about that, I would definitely rather have the money. But I think we will be able to absorb that into our style of living without too much trouble. It represents a couple of dinners per week or cutting back vacation expenses by $5 grand per year. It is at the margins, and in reality it will be absorbed in little pieces here and there. Like gas prices, it is what it is.
With dividend increases of 7% per year, we will more than make up for the increased tax rate in a little over a year. I look at the increased tax rate as an element of inflation, and inflation is the major reason that I am a dividend growth investor. Dividend increases generally outpace inflation. I expect that will happen here.