My Dividend Strategy Doesn't Bow To The Fiscal Cliff

Includes: BDX, BRK.B, CL, IBM, JNJ, KO, MO, T
by: Tim McAleenan Jr.

Some of my fellow Warren Buffett groupies may be aware of what the conditions looked like when Warren Buffett, the Chairman and CEO of Berkshire Hathaway (NYSE:BRK.B), bought his first stock. It was in the spring of 1942. The United States was having a rough go of it against the Japanese in the Pacific, and this was before the tide turned in favor of the Allies at Midway, and I think it's fair to say that it took a real leap of faith to put money into the American stock market at that point. To put it gently, the Wall Street Journal wasn't exactly touting "buy-and-hold" forever stocks at that period in time. This anecdote has had a meaningful impact on my approach to investing. If Buffett found the gumption to buy stocks literally during World War II, I think I can hold onto my Johnson & Johnson (NYSE:JNJ) through a tax increase.

Now, I don't say this to be dismissive of the effects of the government's tax policy. Tax increases do diminish the amount of wealth that hard-working and industrious Americans get to keep for themselves, and I have no intention of cavalierly dismissing the fact that some investors may have to send more of their wealth to Washington instead of spending it on their family or strengthening their household's balance sheet. But I will say this: I am interested in crafting a long-term strategy that can withstand a lot of abuse (tax increases among them) and still allow me to reach my goals. If a tax increase causes me to abandon my strategy, then it may not have been that intelligently conceived for the long term anyway.

I think of long-term investing as a two-part process. The first step is to funnel what you can into retirement accounts. Charlie Munger, the Vice Chairman of Berkshire Hathaway, calls it such a no-brainer that it shouldn't even have to be mentioned. John Bogle, the Founder of Vanguard, once put it this way:

I've been truly blessed by the magical combination of my propensity to save whatever remains each year [and benefit from] the mathematical miracle of tax-free compounding. Now that I've walked the walk personally, I can assure you that it's true. It works! I've continued to put away fifteen percent of my annual salary to this day, dating back to my salary of $250 in July 1951. I invested in the Wellington Fund (shares I own to this day) and then, for most of my later career, largely in Vanguard's equity funds. My experience is a living testimony of how the humble wonders of the tax-deferred retirement plan, soundly invested over the long-term, can build the accumulation of wealth. My own retirement plan is by far the largest single item on our family balance sheet, and while I prefer not to tell the world the exact amount, its current value is little short of awesome.

Putting that $5,000 into a Roth IRA (if you're eligible) probably ought to be one of the first no-brainer steps that an investor can take. When you can benefit from companies like AT&T (NYSE:T) and Altria (NYSE:MO) returning most of their profits to investors in the form of dividends, you can take advantage of what Bogle calls the mathematical miracle of tax-free compounding by receiving high-yielding dividend income every three months that you can diligently redeploy to generate even more dividend income to get the virtuous cycle of wealth-building kickstarted. This stuff is largely immune from the fiscal cliff. Priority one should be depositing money to your retirement account so you can own high-quality assets that generate meaningful income and capital growth beyond the reaches of Uncle Sam. And of course, this statement was true even before the talks of the fiscal cliff arrived.

The next step is assessing the effects of the tax increase on your personal bottom-line. If you're at the highest income threshold and you don't practice any form of tax optimization, you could see your rate go from 15% to over 40%. If I were going to be paying over 40% on dividends, I would focus on companies with low starting yields and high dividend growth rates like IBM (NYSE:IBM) and Becton Dickinson (NYSE:BDX). And I'd probably put about 5-10% of my portfolio into Berkshire Hathaway to dodge the 40% tax so I could benefit from the capital growth without giving Uncle Sam that large of a bite along the way.

Of course, I'm fortunate (if that's the right word) that I'm not facing the prospect of sending 40% or more of my dividend income to Uncle Sam. Seeing an increase of a dividend tax from 15% to something in the 20% range is not going to deter me from investing in a company like Coca-Cola (NYSE:KO) or Colgate-Palmolive (NYSE:CL) that has records of raising dividends and earnings by over 10% annually over the past 25 years.

I assume that no one reading this desires to send more of their dividend income to the government. If the fiscal cliff happens, it's probably not going to be a pleasurable experience for many. But just because an unfortunate tax increase is about to occur, does not mean that behavior needs to necessarily be modified. This is a personal decision for everyone, but the only way that I would modify my behavior in response to the fiscal cliff would be if these two conditions were met: (1) I belonged in the top tax bracket that would have to pay over 40%, and (2) I owned companies like AT&T and Altria that ship off more than 75% of normalized earnings to investors in the form of cash dividends (with the expectation being that the dividend would constitute most of the total return). Otherwise, I'm going to keep on doing what I've been doing all along. First, I focus on maximizing my retirement contributions, and secondly, I focus on owning high-quality assets in taxable accounts that seem poised to grow earnings and dividends in the high single digits for the long-haul. I crafted this strategy with the intention that it could withstand some abuse along the way, and when moderate trouble pops up, I'm not going to abandon it.

Disclosure: I am long BDX, JNJ. 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.