Stop Buying Dividend Stocks!

Subtitle: Until You Read This Article.

I’m not one for hyperbole… I’m more of a “here’s the data, deal with it” person, but I’ll make a vast blanket statement for you today.  You see, you may not care too much either way about the whole ‘fiscal cliff‘ scenario, where an expiration of the so-called Bush Tax Cuts of 2001 and 2003 would reset rates to their previous levels.  Perhaps you make under $200,000 as a single or $250,000 as a couple, so if the cuts expire and President Obama extends them for your income bracket in a second term you wouldn’t worry too much.  Fine – I won’t spend this article discussing what the appropriate level of taxation is for the many strata of incomes earned in this country.  However, I do want to draw your attention to one insidious effect of rolling back the 2001/3 cuts – namely, how the code characterizes dividends.

Capital Gains and Dividends

Think the Fiscal Cliff Doesn’t Affect You? Uh… Think Again.

It won’t shock many of you who worry about the arcana of tax law to find that dividends are already about the worst form of redistributing profit to shareholders.  Say what you will about the timing of share repurchasing plans but a simple truth remains – for tax purposes, they are better than dividends.

Dividends are a double tax.  First, a company is taxed on the profit it makes, and only from the remainder can the dividends be paid.  Second, the investor is taxed on the dividend – either at the qualified rate, or for certain situations at a higher rate (generally for short term holdings).  In some scenarios, that money is taxed a third time – either at the point of sale of some good or service in the form of a sales tax, or upon death in an estate tax.  (I call it double taxation because the third scenario doesn’t always apply).

Now, enter the fiscal cliff scenario.  Today, the top dividend tax rate is 15%, while the top corporate rate is 35%.  Add in state tax rates on personal and corporate income, and it’s already possible for dividend money to be taxed north of 50%.  However, seeing for myself the obsession with ‘passive income‘ around the internet, let’s look at the maximal rate for dividends under a fiscal cliff scenario:

For a person earning $200,001 and up or a couple earning $250,001 and up in 2013:

(100% – 35% Corporate Tax Rate + x% State Corporate Tax Rate – d1 (deductions due to state tax))

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(39.6% new top tax rate + 3.8% levy due to the Patient Protection and Affordable Care Act) + Individual State Taxes – d2 (individual deductions due to state tax)= 65% untaxed profits – 43.4% top individual federal rate = 36.79% profits retained

63.21%  taxes + net state taxes after deductions (individual and corporate)

Why so high?  I told you above that capital gains and dividends are treated the same – that’s only been the case since 2003.  If that law is retired, dividends will be taxed at the highest personal rate.

So, How Does it Affect Me?

Elementary, dear reader: you may not care too much if high earners have to pay more money on dividend stocks, but they certainly do.  The effects are doubled, too – since many of those company owners happen to be high earners, they understand that any money they pay as dividends is sure to make its way back to their own shares – that 63% or more will go into the pockets of governments at various levels.  That wouldn’t matter much except the those high income earners tend to hold a lot of stock – enough to move markets, easily.

So, what am I saying?  You might be chasing yield on the deck of the Titanic as high earning investors rearrange their stock purchases as 2012 draws to a close.  You see, it was the case before that two stocks gaining 10% – one with capital gains and one with all dividends – were worth the same to an investor.  Now?  Not so much – at the Federal level, you’re talking 23.8% federal taxes on the former and a massive 43.4% on the latter.

Your dividend stocks still might be a great deal – but don’t get crushed if there is a mad dash to the exit.

Caveat Emptor.

Did you know that the characterization of dividend income was changing?  Do you purchase lots of dividend paying stocks?  Will you be changing your portfolio composition near the end of the year… or now?