The Dividend Cliff

Seriously, folks.  This topic is serious enough for me to write two articles about it.

Since the last time we covered the forthcoming dividend tax increases, a few things have happened:

“I’m six feet from the edge and I’m thinking: maybe six feet ain’t so far down?”

• Barack Obama was reelected President
• The Senate and the House remained in the hands of the Democrats and the Republicans, respectively (meaning the status quo is king)

The Highest Part of the Fiscal Cliff

As we detailed in the last article, the tax treatment of dividends is on pace to change quite a bit in the new year.  To recap, the 2001 and 2003 tax cuts changed the treatments of dividends to be in line with capital gains – previously, all dividends (regardless of the length of time a stock was held) were treated like ordinary income.  Additionally, ordinary income was previously taxed at a rate of up to 39.6%.  On top of that, the Patient Protection and Affordable Care Act levies a surcharge of 3.8% on investment income for a total rate of 43.4%.

In a bit of a wrinkle since the last article, there have been additional changes which will affect investor behavior – including a tax increase in California (investment earnings are treated as ordinary income).  As we showed last time, the previous plan could tax the dividends of high earners at a whopping 63.21% once corporate earnings were factored into the equation.

“This Doesn’t Affect Me”

You wouldn’t think so – but the truth is, even if your taxes end up staying exactly the same (or lowering), you’ll still be affected.  Why?  Simple – it isn’t just foreigners, the middle class, and rich people with tax advantaged accounts in your stocks.  Rich people with normal brokerage accounts are also invested in those stocks, and they have an outsized voice in the matter.  If you don’t believe me, note that the investor class has already got many companies to accelerate their dividend schedules (or worse, have already cut them).

So, that’s one issue – the stocks you bought trying to build up your passive income portfolio are hurting from the fiscal cliff which the rich are being herded over.  The second issue?  All the stocks that don’t cut their dividends will become less attractive in taxable accounts to those rich people – meaning that, even if rich investors don’t sell, they probably won’t be buying in 2013.

Now What?

Here’s the thing – this issue isn’t getting a ton of press, but you aren’t the first person hearing about it.  You need to evaluate your buys (as you should anyway) not solely on their dividend prospects, but also everything else relevant to the company.  And, yes, you should consider selling if you’re at an attractive exit point.  I said consider for a reason – note that some of this news is already priced in, and you might have already missed the boat.

Play it by ear, and be careful out there.  Don’t get too close to the edge of the cliff.

Yeah, I quoted Creed.  Got a problem with it?