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On December 31, 2012, all of the Bush-era tax cuts are set to expire, including the very favorable 15% tax rate on qualified dividends. In addition, for individuals earning $200,000 and couples earning $250,000, there will also be a new 3.8% tax rate that comes as part of the Affordable Care Act on certain types of income, including dividends, capital gains and rental income. With no action between now and then, the top tax rate on dividends will nearly triple to 43.4%. Note: If the tax cuts expire, dividend income will be taxed as ordinary income.

While we think that the dividend tax cuts will ultimately be extended in some form (since it would be political suicide to allow the dividend tax rate to revert back to ordinary income levels at this point), we also think that investors should hope for the best, but plan for the worst.

What Is The Worst Case Scenario?

For those on fixed incomes and counting on dividends to help pay their bills, the thought of having to pay higher taxes could seem devastating. According to the most recent IRS data, more than 63% of taxpayers with qualified dividend income are 50 and older. In addition, it is estimated that one Baby Boomer will turn 65 every 10 seconds for the next 10 years. Talk about bad timing for a dividend tax hike!

The worst case scenario for dividend investors is that all Bush-era tax cuts expire (including the dividend tax). The table below highlights the estimated tax rates for 2013 under this scenario.

If you are relying on dividend income to pay your bills, it's unlikely that you are in the highest tax bracket. However, there is a good chance that you would fall into the 28% or 31% brackets. At first glance, it would appear that your tax rate on dividends will essentially double. However, when you do the math, you will find that your effective tax rate will be much lower than your marginal rate.

For example, a retired married couple (filing jointly) with $80,000 of dividend income would have a marginal tax rate of 28%. However, their effective tax rate would be 18.2% (since the first $60,550 of dividend income would be taxed at 15%). In this example, the couple's after-tax dividend income would decline by only 3.7% if the Bush-era tax cuts expire completely (see table below). Obviously, any decline in after tax income is undesirable, but the worst case scenario is probably not as bad as most investors think.

Instead of singing the higher dividend tax blues, investors should focus on replacing the after-tax income that they could be losing. In the example highlighted above, the couple would only need a slight increase in their average dividend yield (from 4.00% to 4.15%) to completely offset their higher tax rate (see table below).

While we can't control how Washington will navigate the looming fiscal cliff, we can plan for the worst by adjusting our investment strategy to account for any adverse changes that we will face. As discussed above, if dividend taxes increase, investors need to focus on increasing their income yield to offset the hike. Now we certainly don't recommend that investors run out and increase their exposure to high yield stocks to accomplish this. Investors can utilize several simple strategies to increase their income yield without drastically increasing their risk.

Strategy #1: Patiently Wait For Your "Buy Zones" And Build Your Position Over Time

If you are following along as we build our real-time Model DIY Dividend Portfolio, you know that a big part of our strategy is to patiently wait for low risk entry points (i.e., our "Buy Zones") on our high-rated dividend stocks. It's not only the prudent thing to do to manage downside risk (since even good stocks have healthy corrections from time-to-time), but it also helps you maximize your yield on cost. In the example below, if you would have purchased McDonald's (MCD) last month around $90.00, your yield on cost would be 3.4%. However, if you had patiently hung around the hoop a little longer, you could have purchased the stock in the mid $80s and increased your yield on cost by 20-30bps.

We focus on four key levels of support when determining a "Buy Zone", which are points at which long-term dividend investors should feel comfortable starting to build a position in the respective stocks:

  • Technical - Support from short and long-term trend lines
  • Volatility - Target correction levels based on historical volatility and draw down
  • Valuation - Support levels based on historical valuation multiples
  • Yield - Support levels based on forward dividend yield

Regardless of what methodology you use to establish a "Buy Zone", it's almost impossible to pick a bottom for a stock and we recommend that investors build their long-term dividend positions over time. In the case of McDonald's, we starting buying the stock around $88.50 and through a series of additional purchases, we decreased our cost basis by almost $2.00 to roughly $86.50 (which also increased our yield on cost by over 10bps).

Strategy #2: Utilize A Covered Call Strategy On Your Dividend Stocks to Enhance Your Income

Although the covered call strategy can be utilized in any market condition, it is most often employed when the investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value. Investors should consider the following three components when choosing a strike price for their covered call strategy:

  • Premium Yield (%) - The additional yield generated by the call premium (which is your downside protection from the current price). The more volatile the stock, the higher the premium (i.e., the higher the risk).
  • Margin of Safety (%) - The margin of safety is the amount that the stock would have to drop from the current level (before expiration) to completely offset the call premium and the dividend yield. Note: If the underlying stock does not pay a dividend, the Margin of Safety will be equal to the Premium Yield.
  • Upside Profit (%) - The upside profit, which assumes that the option is assigned at expiration, is equal to the premium received + dividends received + the difference between strike price and current price. The more volatile the stock, the higher the expected upside profit.

The table below highlights various covered call options for Microsoft Corp (MSFT).

Depending on which covered call option you choose, you could enhance your income yield on MSFT by 80-300bps over the next 3-4 months. Clearly, covered calls are a tradeoff between premium yield and upside profit. The higher the premium yield, the lower the upside profit (i.e., the higher the probability that the buyer of the option will exercise his right to purchase your stock).

As a long-term dividend investor, you would obviously like to avoid losing your stock. However, we feel that this is a prudent risk to take in the current market environment. Stable risk-adjusted income yield will continue to be difficult to come by in the years to come and investors should definitely consider implementing a covered call strategy in their portfolio.

What About Dividend Stocks That Don't "Qualify"?

Dividends paid by tax-exempt corporations or trusts such as Business Development Corporations ("BDCs"), Master Limited Partnerships ("MLPs"), or Real Estate Investment Trusts ("REITs") are considered non-qualified, and are typically taxed at ordinary rates. These stocks, which tend to fall into the "high-yield" category, will NOT be affected by a dividend tax hike because non-qualified dividend income is already taxed at ordinary rates. As such these stocks may hold up better if the worst case tax scenario comes to fruition.

That said, investors can utilize the same strategies described above for non-qualified stocks as well (you could always use more income, right?). As a matter of fact, we recommended purchasing mortgage REITs and MLPs a few weeks ago during the broad-based selloff as many of these stocks were in their respective "Buy Zones". Mortgage REITs, like Annaly Capital Management (NLY) and American Capital Agency (AGNC), have taken it on the chin since the Fed announced its open-ended plan to purchase agency mortgage backed securities back in September. Both Annaly and American Capital Agency are still trading below book value (0.89x and 0.97x, respectively) and we believe that these stocks could rally significantly in 2013 regardless of what happens with dividend tax rates.

What About Dividend Stocks Held In Tax Deferred Accounts?

Investors that hold their dividend stocks in a tax-deferred account (like an IRA) will not be affected by a dividend tax hike. As dividends are paid into your IRA account, they are tax-deferred and not currently taxable to you, unlike dividends in a regular taxable investment account. As such, the recent legislation classifying some stock dividends as "qualified," and therefore eligible for a reduced tax rate, is irrelevant to IRA account holders. When distributions are taken from an IRA account, they are immediately taxable at ordinary income rates. Even if a dividend paid into an account was originally a "qualified" dividend, when it is withdrawn from an IRA, that special tax status vanishes and it is taxed at ordinary income tax rates.

Conclusion

While a dividend tax hike would be an unfortunate reality for income investors, it certainly shouldn't cause a mass exodus from dividend stocks. The Fed has essentially guaranteed that interest rates will remain near zero percent until at least 2015 and good risk-adjusted yield will continue to be hard to come by. In our opinion, dividend stocks will remain one of the best income-generating options for investors for the foreseeable future (tax hike or not). Investors should also remember that dividend tax rates are currently low by historical standards.

Obviously, investors have no control over what Washington decides to do regarding future tax rates. However, we feel that DIY Investors should stay the course with their dividend investment plan. Your after tax income may end up being slightly lower, but there are limited alternatives out there for good risk-adjusted yield. In addition, we also recommend that investors implement conservative option strategies (like covered calls and cash-secured puts) to augment future income. Note: We are currently implementing these option strategies in our Model DIY Dividend Portfolio.

In the worst case scenario highlighted above (if all Bush-era tax cuts expire), there will likely be a short-term sell-off in dividend stocks. However, in our opinion, a tax hike-driven pullback will be a HUGE buying opportunity for long-term dividend investors. Individual tax rates should have a minimal effect on stock valuations and we believe that institutions will also see any pullback as a prime opportunity to add to their positions.

Source: Strategies For The Looming Dividend Tax Hike: It Won't Be As Bad As You Think