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One reason I love investing is that it's one of the few pursuits in life where you can go against the masses and be rewarded if you are right. My career in investing really began in late 2008 and early 2009 when there was a massive amount of gloom and doom in the market. Commodity stocks and REITs, in particular, looked extremely attractive to me because the market was practically assuming a second-coming of the Great Depression. I viewed that outcome as unlikely and began buying in like a madman, often buying great companies at prices below their net asset values.

I didn't buy into the gloom and doom of 2008 /2009, but I'm actually perplexed at how much optimism there is right now. While it's purely anecdotal, over the past month, I've probably read more investment-oriented articles suggesting that the "Fiscal Cliff" is not a big deal, than those arguing the converse. In my view, the fiscal cliff is a HUGE DEAL! One that will (and already is) impacting stock prices significantly, and could possibly create another recession. At the same time, there are still beneficiaries.

For this article, I want to focus on one particular class of investments that will be altered the most by fiscal policy changes: dividend-paying stocks. My view is that dividend paying stocks could get hit hard over the next few months, but will prove to be an excellent opportunity for investors using tax advantaged accounts, such as IRAs.

The Fiscal Cliff

The "fiscal cliff" is essentially a series of tax increases that are projected to raise $535 billion annually for the US Federal government. Many of these tax increases are the result of the expiration of the 2003 tax cuts and the 2009 Stimulus Act, while others are imposed as a result of the Affordable Care Act.

There are three major tax increases in the cliff that will have a significant impact on investments. The top capital gains tax rate will increase from 15% to 23.8%, the top dividend tax rate from 15% to 43.8%, and the top income tax rate from 35% to 39.6%. Note that of the three, the dividend tax increase is the most dramatic, nearly tripling the top rate.

I'm unsure how the fiscal cliff will be resolved. While it seems like the majority of investors view a deal as likely, I seem to be more pessimistic than most. I'd give 50% odds that we go off "the fiscal cliff," and maybe 45% odds that we get some sort of short-term deal that includes some significant tax increases, but only minor spending cuts. The likelihood of investment tax increases is very high (over 98%, as some are already included as a part of Obamacare) and the possibility for the full dividend tax increase might be around 65%.

These numbers should frighten dividend investors. No group of stocks will be more impacted by the fiscal cliff than dividend-paying stocks. We've already seen a significant decline in these stocks, and I'm not sure that the exodus is over yet. However, once we see some certainty again, I think it's very likely that these stocks experience a rapid rebound.

The Dividend Tax Hike

It's important to note which dividend-paying stocks will be hit by the increase in the top dividend rate and which ones won't. REITs, MLPs, and BDCs will likely not be harmed much by this increase since they are normally taxed at ordinary income tax rates. (Indeed, it's possible that they benefit.) Most other classes of dividend paying stocks, on the other hand, will be significantly impacted. This includes most prominently, utility stocks.

Let's take a look at how a REIT would be impacted versus a utility. The chart below shows a REIT and utility with a 5% pre-tax dividend yield. You can see the pre-cliff versus post-cliff picture for each.

The after-tax yield of the REIT falls about 9.1% under the "fiscal cliff" scenario, which is a moderate hit. Whereas, the after-tax yield of the utility falls 35%, a major hit! Notice that the utility with the 5% yield actually had a significantly higher post-tax yield in the pre-cliff scenario (4.3% for the utility vs. 3.3% for the REIT), while the situation reverses post-cliff.

We can also look at the broader picture. Remember, dividend and capital gains taxes are often a second layer of taxes on investment. The first layer is the corporate tax. REITs are exempt from corporate taxation, but utilities are not. The chart below shows a pre-cliff versus post-cliff analysis of a $1 million investment in a REIT and a utility. Both hypothetical investments will produce a $100,000 pre-tax profit.

(click to enlarge)

If we assume that both investments have a pre-tax ROI of about 10%, I came up with around a 6.5% ROI for the REIT and a 5.2% ROI for the utility before the cliff. After the cliff, the ROI for the REIT falls to 6.0%, a 7.7% drop. The ROI for the utility falls to 4.3%, a 17.4% decline.

This is all based on the assumption of a 35% corporate tax rate. We won't get into a discussion of effective corporate tax rates, because it makes the entire exercise infinitely complicated, but you can see how utilities become even more unattractive under the fiscal cliff scenario.

The Plunge

Not surprisingly given the data above, we've seen a significant drop in stocks that are eligible for the special dividend tax rate. However, it would appear from the data that the market did not begin to anticipate this until around November 1st; a few days before President Obama's re-election. Since that point, these stocks have plunged relative to the market.

Below is a sampling of dividend-paying stocks affected by the dividend tax increase. I've selected seven utilities, since that's the sector I'd peg as being most adversely affected. The seven utilities examined are Duke Energy (NYSE:DUK), Exelon (NYSE:EXC), Southern Company (NYSE:SO), Pepco (NYSE:POM), Entergy (NYSE:ETR), PG&E (NYSE:PCG), and Consolidated Edison (NYSE:ED).

I also decided to look at the two major telecoms: AT&T (NYSE:T) and Verizon (NYSE:VZ), as well as few dividend paying stocks that I found interesting: Pitney Bowes (NYSE:PBI), NYSE Euronext (NYSE:NYX), Waste Management (NYSE:WM), and Dow Chemical (NYSE:DOW). I selected Pitney Bowes because of its extraordinarily high dividend yield, while the others were simply strong companies on the S&P 500 index that came up in a filtered search.

(click to enlarge)

In this 3 week period, the S&P 500 average fell 4.1%. The seven utility stocks (NYSEARCA:XLU) sampled here averaged a 10.4% decline, a significantly larger decline. The overall sample saw an 8.2% average decline.

These declines are particularly unusual because most of these stocks are considered to be "lower risk" than the broader market. It's particularly odd to see lower-risk dividend stocks endure a much larger decline than the S&P 500.

Some have argued that since there are so many tax-exempt accounts investing in these stocks already, the tax increase will be irrelevant. The data above seems to discredit that view to some extent. Even if 80% of the float for these stocks is owned in tax advantaged accounts, the dividend tax increases will still significantly impact the other 20%. And my guess is that a sizable portion of these non tax advantaged owners will want to get out.

On that note, it's worth pointing out that there has been some significant insider selling activity at both Exelon and Duke Energy recently. I'm sure there are other non tax advantaged investors in these stocks, as well, that might get pinched if the tax increases do indeed go through.

Dividend Stocks: The Anti-Municipal Bond

It's clear from all of the above that the market has assigned a higher probability for a significant dividend tax increase since October 31st. There's no other way to explain the dramatic plunge in dividend stock prices. While I do not make the comparison above, one could also take a look at REIT and MLP prices versus utility stock prices and see that the primary exodus is from stocks that will be affected by the dividend tax increase.

If we do indeed go through with an increase in the dividend tax to 43.8%, we could see an interesting scenario develop. Essentially, by making dividend-paying stocks tax disadvantaged, it has radically changed the eligible pool of buyers. This could result in a significant short-term drop in prices.

If the tax change goes through, the primary investors that can take advantage of the large dividends are investors with low ordinary income tax rates and investors who hold assets through tax advantaged accounts, such as IRAs. It's unlikely that there will be a mass influx of lower-middle income investors (with lower income tax rates) into dividend-paying stocks, so this means that essentially, dividend stocks could become completely dominated by tax advantaged investors.

In other words, dividend stocks might almost become the inverse of municipal bonds. For those unfamiliar with muni bonds, they are tax exempt, which means that they benefit investors with the highest tax rates the most. As a result, there's no reason for most lower-tax investors to invest in them, since pricing will be based on benefits to investors with the highest tax rates. If you hold a tax advantaged account, municipal bonds make virtually no sense at all, since you receive no benefits versus an investor with a 35% tax rate.

With dividend paying stocks being taxed at a disadvantaged rate, we'd see the reverse situation. Since the tax rates will become so extraordinarily high compared to other investments, the class that benefits the most is obviously tax-advantaged investment accounts. This likely means that there will be an exodus by other (non tax-exempt) investors out of these stocks, and eventually, more tax-advantaged investors will flood into these investments as the yields increase.

A Great Opportunity for the Tax Advantaged

For investors who own IRAs or other tax advantaged retirement accounts, these dividend-paying stocks provide huge opportunities. While it's completely possible that they continue to decline through the end of the year, the increasing yields will be very attractive so long as one doesn't have to pay the dividend taxes.

As we can see in the chart above, some of these stocks have declined significantly. The average yield on my seven utility stock sample increased from 4.7% to 5.3%. If we do indeed see the top dividend tax rate increase to 43.8%, my bet is that those yields will increase even more in the next month or so.

Conclusions

Whether you can invest through a tax-advantaged account or not, the fiscal cliff is a big deal and it's worthwhile to keep an eye on it. If the full dividend tax increase goes through, many dividend-paying stocks will make very little sense for investors who aren't investing through tax-deferred accounts. The prices are also likely to continue to decline as the market adjusts to this new reality. I would recommend staying away until there's more certainty on the issue.

For non tax-advantaged investors looking for income-producing stocks, I would recommend looking at REITs, MLPs, and BDCs instead. Make sure to keep an eye on the fiscal cliff, because if there is a compromise that results in the capital gains and dividend tax rates staying comparable, then utilities and other stocks that benefit from the special dividend tax rate will again be attractive, and will likely present ideal buying opportunities.

For tax advantaged investors, my advice is to buy in and take advantage of an exodus away from dividend-paying stocks. You can buy in now, or wait to see what happens in the next 4-6 weeks (as the prices may fall more), but you will be buying in at an ideal time regardless.

As for the fiscal cliff, even if it benefits tax-advantaged accounts in some ways, my overall view is that it could cause the broader market to decline for several months. For this reason, I am taking more of a "wait-and-see" approach to investing right now.

Source: Fiscal Cliff Could Make Dividend Stocks Very Attractive For Retirement Accounts