Dividend Portfolios And The Looming Fiscal Cliff

by: Adam Aloisi

As Republicans and Democrats continue their gridlocked ways in Washington, their dallying about could have serious deleterious effects on all of us who invest in dividend paying stocks. Remember the ending to the movie "Thelma and Louise?" It's probably a good analogy to the situation. In this case Congress is playing the role of Susan Sarandon driving the car, while President Obama is riding shotgun in the role of Geena Davis. In a nutshell, the situation for dividend investors is this: if nothing is done by December 31, taxes on ordinary dividends held outside a qualified account will rise substantially for investors in higher tax brackets.

The Law

The current maximum tax rate for qualified dividends is 15%, which has been in effect since President Bush signed JGTRRA back in 2003. That rate was extended in 2005 and then again in 2010. If I were a betting man, I would expect that Congress will uncomfortably get together in a last minute session and extend the rules again by the end of the year. But given the dysfunctional nature of our current crew of lawmakers, I think I'd be inclined to place insurance on that wager.

If Congress does allow us to go speeding over the cliff, a la Thelma and Louise, dividend taxation will be at ordinary income rates as of January 1, 2013 - meaning that an investor in the 28% tax bracket will see their dividend tax bill basically double next year. For those dependent on dividend income, especially those already struggling with investment strategy in a ZIRP world, this is a significant and potentially worrisome development.

What it Means

To illustrate the potential impact a dividend portfolio, I've created a hypothetical $750,000 diversified portfolio consisting of ten well established dividend-paying equities with equivalent $75,000 positions. (Current Yields effective 8/28 at 11AM)

Stock Investment Current Yield [CY] Annual Income at CY
British Petroleum (NYSE:BP) $75,000 4.56% $3420
Sysco (NYSE:SYY) $75,000 3.54% $2655
Pitney Bowes (NYSE:PBI) $75,000 11.19% $8392.50
Procter & Gamble (NYSE:PG) $75,000 3.35% $2512.50
Pepsi (NYSE:PEP) $75,000 2.94% $2205
Pfizer (NYSE:PFE) $75,000 3.67% $2752.50
Automatic Data (NASDAQ:ADP) $75,000 2.71% $2032.50
Altria (NYSE:MO) $75,000 5.12% $3840
Hasbro (NASDAQ:HAS) $75,000 3.85% $2887.50
American Elec. Pwr (NYSE:AEP) $75,000 4.38% $3285

The above portfolio generates exactly $33982.50 a year in dividends with a blended yield of 4.53%. If this portfolio owner and tax payer sits in the 28% bracket and lives say in the state of Pennsylvania, which takes another 3 percent, he or she would pay 18% or $6140 in combined federal and state tax in 2012. Next year, if the fiscal cliff comes into play, assuming the same portfolio, the tax bill goes up to 31%, or $10540, an added tax burden of $4300.

If Congress continues not to act, the damage becomes even more extensive and noticeable. In the following two charts, I track the 5-year progress of the above portfolio assuming no reinvestment of net dividends at the end of the year (dividends - tax payments), and a 5% portfolio increase to cover hypothetical capital growth each year. I kept the blended yield static at 4.53 percent in both examples.

5 Year Portfolio Progress in Current Tax Scenario

Year Beginning Portfolio Value Net Dividends (at 4.53% yield and 18 tax rate) Ending Value (5 percent return)
1 $750,000 $27859.50 $787,500
2 $787,500 $29353.48 $826,875
3 $826,875 $30715.10 $868,218
4 $868,218 $32,250.85 $911,628.90
5 $911628.90 $33863.38 $957,210.34

Total dividends paid = $150,042.31 5-year total return = 47.63%

5 Year Portfolio Progress With Fiscal Cliff Assumptions

Year Beginning Portfolio Value Net Dividends (at 4.53% yield and 31% tax rate) Ending Value (5 percent return)
1 $750,000 $23,442.75 $787,500
2 $787,500 $24,614.88 $826,875
3 $826,875 $25,846.32 $868,218
4 $868,218 $27,137.89 $911,628.90
5 $911628.90 $28,494.79 $957,210.34

Total dividends paid = $129,536.63 5-year total return = 44.90%

This example shows that this investor will end up with more than $20,000 less in dividend income over the span of the five years, should the fiscal cliff come to fruition.

Strategy For Non-Income Dependent Dividend Investors

To start to retool an entire investment portfolio based on the possibility of the fiscal cliff would be foolhardy. But, investors who own dividend stocks and are not dependent on the income, should start to consider whether a portfolio shift towards capital growth would be worthwhile from a tax perspective. This would be something to ponder now and start implementing next year, assuming we plunge over the cliff.

I suggest consideration of this because if Congress does not extend current rules, long-term capital gains rates, which currently max out at 15% - currently the same as dividends, will not go up as much as dividend rates will in 2013. Long-term rates max out at 18%, and investors who hold equities for five years or longer would only pay 15%. Short-term rates would not change.

To illustrate the potential tax savings over five years, picture two stocks or portfolios worth an initial $100,000 that deliver a total return of 10% a year for five years. Stock/portfolio A pays a 4.5% dividend and provides 5.5% capital growth over the five year span (similar to the $750K portfolio above), while Stock/portfolio B provides simply 10% capital growth over the five years. Both portfolios are simply held, no transactions are made or dividend reinvestment done, and both are then liquidated at the end of the period. The investor is in the 28% tax bracket and there is no state taxation involved .

Total Return portfolio:

Year Starting Amount Net Dividends (4.5% yield/ 28% rate) 5.5% Growth Adjustment Ending Value
1 $100,000 $3240 $5,500 $105,500
2 $105,500 $3418.20 $5802.50 $111,302.50
3 $111,302.50 $3606.20 $6121.64 $117,424.13
4 $117,424.13 $3804.54 $6458.33 $123,882.46
5 $123,882.46 $4013.79 $6813.53 $130,695.99

Total Net Dividends Paid: $18,082.73 Liquidated Capital = $126,091.59

Total Capital at end of the five years = $144,174.32

All Capital Return Portfolio

Year Beginning Value 10% Growth Adjustment Ending Value
1 $100,000 $10,000 $110,000
2 $110,000 $11,000 $121,000
3 $121,000 $12,100 $133,100
4 $133,100 $13,310 $146,410
5 $146,410 $14,461 $160,871

Liquidated and Total Capital at end of the five years = $151,740.35

After all is said and done, the all capital portfolio returns about $7500 more at the end of the five years. That's pretty substantial for an initial $100,000 investment and an apple to apples total return comparison.

In the end, hopefully the government won't be foolish enough to drive us over a cliff. But in the event they do, it's not a bad idea to start to think about the potential implications on your dividend portfolio and how you might react to the situation if it becomes reality.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.