The fiscal cliff deadline is less than a month away, and Washington is looking at higher taxes on dividends for high-income investors as a way to diminish the burgeoning deficit. Nevertheless, dividend exchange traded fund investors should not overreact to the proposed tax hikes, says an executive at a firm that manages several dividend-themed ETFs.
Jeremy Schwartz, director of research at WisdomTree Investments, notes that on January 1, the preferential 15% tax rate will end and investors will have to deal with 20% capital gains and dividends taxed at ordinary income rates, reports Matt Nesto for Yahoo Finance.
"Since the President enacted a 0.9% Medicare payroll tax, plus another 3.8% to fund Obamacare, the highest tax on dividends is set to go up to 43% under that scenario for the highest income earners," Schwartz said in the article.
Nevertheless, Schwartz pointed out that there "are number of mitigating factors" that diminish the impact of the changes. Specifically, almost 50% of dividend-generating stocks are held in "tax insensitive accounts," like IRAs, pension funds, endowments and non-profits. A sell-off in anticipation of the fiscal cliff "could motivate these investors" to pick up where others left off, Schwartz added.
Moreover, in the 50% of none tax-free accounts, only half of the holders, or 25% of overall dividend stock holders, are subject to the top tax rate.
Oddly enough, Schwartz pointed out that tax rates and market performance seem to follow an inverse relationship as we've experienced the lowest rate on dividends and gains in 70 years.
"This past decade was one of the worst for both dividend-paying stocks and the broad market," Schwartz said. In contrast the last time dividend taxes were raised from 31% to 39.6% under President Clinton, "it was one of the best decades for dividend stocks."
"The bottom line conclusion of our research is that the market environment is more important than the tax environment," Schwartz said.
Some dividend ETFs include:
- Vanguard Dividend Appreciation (VIG): 2.08% yield
- iShares Dow Jones Select Dividend Index Fund (DVY): 3.49% yield
- iShares High Dividend Equity Fund (HDV): 3.28% yield
- SPDR S&P Dividend ETF (SDY): 3.14% yield
- Vanguard High Dividend Yield Index Fund (VYM): 2.97% yield
- WisdomTree Dividend Top 100 Fund (DTN): 4.57% yield
- First Trust Morningstar Dividend Leaders (FDL): 3.44% yield
Max Chen contributed to this article.
Full disclosure: Tom Lydon's clients own DVY and VYM.