Dividend Taxation: 5 Points to Ponder

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Beginning January 1, 2011, the Bush tax cuts are set to expire, meaning that dividend taxation could increase. Currently in the U.S, dividend investors enjoy a maximum of 15% taxation on qualified dividends, but this could increase to 39.6% for those in the highest tax bracket if Congress does not act to keep dividend taxation low. Even for most people in the other tax brackets, dividend taxation could increase, but the effects won’t be as dramatic. There are a variety of outcomes that could occur, ranging from the tax cuts being made to stay, or facing a modest bump up to 20% or so, or staying low for those in the lower tax brackets but soaring up high for those in the highest tax brackets, or going high across the tax bracket board.

I am not a political analyst or a tax professional, and unfortunately I cannot seem to locate my crystal ball, so at this time I cannot predict what will occur in regards to dividend tax rates for 2011 and beyond. But there are a variety of options to consider and things to keep in mind.

1. Dividends have been around for far longer than the Bush tax cuts of this past decade. Dividend-paying companies have been a great investment choice throughout this past century. Many of them are mature, cash-generating companies that are excellent at allocating their capital in the most optimal way to grow shareholder value. So one option, facing the possible removal of these tax cuts, is to do nothing, and to continue investing in great dividend-paying companies. This will certainly be one of the paths I take. Lower taxes are always a plus, but it’s important to relax and realize that taxes will not have an absolutely devastating effect on dividend-growth-investing.

2. Companies may consider using more of their money to pay for share repurchases. Companies can return value in several ways to shareholders. The first is that simply by increasing their profits, their shares will likely follow and their investors will have increased value in their holdings. The second is that companies can pay out a portion of their profits as dividends to shareholders on a regular basis. The third is that companies can repurchase some of their own company shares and cancel them, effectively reducing the total number of shares in existence and theoretically increasing the value of each one (as each share now represents a larger percent of the corporation). Many companies strive to use all three of these methods, as each has their benefits. In the face of higher dividend tax rates, companies may put more of their resources towards share repurchases as they won’t be taxed in this way, but the effect shouldn’t be too dramatic because as previously stated, dividends are nothing new; they have existed before these tax cuts and they will exist long after.

3. It’s important to make good use of retirement accounts that offer tax advantages.

4. MLPs and other partnerships will be largely unaffected. These partnerships pay distributions instead of dividends, which are essentially the same but have significantly different tax implications. These partnerships act as flow-through entities that are not subject to the same double taxation that dividend-paying companies face. (Double taxation in this case means that when a company makes a profit, they are taxed on that profit, and then when they distribute some of that after-tax profit to shareholders in the form of dividends, those shareholders are taxed on those dividends as income.) Partnerships on the other hand often offer fairly high distribution yields and have great tax advantages compared to companies. Brookfield Infrastructure Partners (NYSE:BIP) is one such example, and is a current holding of mine that I have performed a stock analysis on.

5. It’s possible to sell options (covered calls) to boost the income from your investments. There are pros and cons to this method, and such a tactic may be useful for some investors.

My concluding thoughts here are that, essentially, nothing about my investing style will change regardless of what Congress does with the dividend taxation laws. Dividend-paying companies have performed well long before these tax cuts were in place and there is no sign of stopping. The market may overreact in the short term to any decisions by Congress that negatively affect dividends, but long-term investors will be buffered against such instability. Partnerships remain an attractive option and may become even more attractive, as they have all the primary benefits of dividend-paying companies and for the investor are very similar.

Let me know what you think about these possible tax changes and how you will react with a comment.