There has been a lot of concern lately about the fiscal cliff and the projected increase on the top dividend rate to 39.6%. The potential for a massive outflow from dividend stocks as high income investors move their assets is certainly there. However, I think the probability of this actually happening is very low. Let's take Chevron (CVX) for example.
Rich Guy Bob has 1,000 shares of CVX, paying him a dividend of $3,500 in 2012. At the current tax levels his after-tax income from this investment would be $2,975. If the maximum dividend tax increase hits, his after-tax income in 2013 would be $2,115, a difference of $860 or 40%. But what's the difference in effective yield? Let's assume Bob bought 1,000 shares of CVX for $100, for a cost-basis of $100,000. That makes his effective yield for 2012 2.975%. With the tax increase his effective yield would be 2.115% in 2013. Wow, taxes suck. Now let's take a look at Bob's other options.
- He can move his assets to non-dividend paying stocks and be subject to Mr. Market's whims. Viable option, but unfortunately his income stream gets dammed.
- He can invest in corporate or government bonds. Unfortunately he runs into the same tax increase problems.
- He can buy municipal bonds. He dodges the tax increase and still is able to generate income. But if Congress does away with the tax exemption for muni bonds, that causes a double whammy of plummeting income and value loss. Or the municipality could default. Either way, muni bonds are not looking so hot right now.
- He can hold his money as cash. Got to love opting for an asset that "pays virtually nothing and is certain to depreciate in value." (Warren Buffett)
All of a sudden getting paid over 2% a year to own a dividend champion with a strong history of increasing earnings doesn't seem too bad. All the inherent values in investing in solid companies that have a long history of increasing dividends year in and year out are still intact. Let's assume CVX raises its dividend again next year to $3.80, in-line with its 5-year average DGR of 8%. Now our 2013 after-tax dividend yield is 2.295%. And when CVX raises its dividend the next year, our after-tax yield grows again. Identifying our best possibilities for returns, no matter what the tax or political environment, should be our #1 goal as investors. And CVX and other companies such as Colgate-Palmolive (CL), Coca-Cola (KO), PepsiCo (PEP), AFLAC (AFL), and Becton, Dickinson and Co (BDX) that have proven themselves time and time again, allow us to build a reliable, growing income stream for years to come.
To summarize, yes a drastic dividend tax increase is going to hurt high income investors. But the bottom line is these investors will still seek income-producing investments, and there honestly aren't many rosy alternatives out there. To paraphrase Warren Buffett: It's not like people are going to say, "We'll I wouldn't invest in a company like Johnson & Johnson (JNJ) that has paid increasing dividends every year for the past 50 years if the dividend tax rate is too high. I'd much rather leave it in my savings account and earn a tenth of 1%."