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Investors have piled into dividend stocks as the only defense against huge decreases in portfolio income. But with big tax changes slated to take effect in 2013, some experts believe that right now might be exactly the wrong time to buy dividend payers. Are they right?
Last week, NYU Stern professor Aswath Damodaran wrote a blog post on the coming fiscal cliff and the impact it could have on dividend stocks in particular. Later in this article, I'll get more specific about which stocks are most likely to see effects from higher taxes on dividend stocks, but first, let's take a closer look at Professor Damodaran's argument.
The fiscal cliff and you
The crisis we're facing now is a direct result of the way in which tax cuts were structured over the past decade. In 2001 and 2003, new tax laws reduced rates on ordinary income, dividends, and capital gains substantially, with one of the biggest benefits being given to dividends. For most stocks, dividends had their maximum tax rate reduced to 15% -- a big savings over prior law's treatment of dividends as ordinary income potentially subject to much higher marginal tax rates for high-income taxpayers.
With these tax laws, though, was a catch: They would expire in 10 years. After a two-year extension back in 2010, these cuts are now once again slated to go away at the beginning of 2013, and the coming election gives politicians little incentive to do anything about the looming deadline until after the first week of November.
Damodaran does a good job of explaining what impact higher dividend taxes should have on rational investors. Essentially, he argues that investors value stocks based on their after-tax dividend yield. So if taxes on dividends rise, investors will demand a higher pre-tax dividend yield in order to end up with the same amount of income after taxes.
To show his work, Damodaran goes through a concrete example in valuing the S&P 500 under a change in tax laws. Based on his latest observations, he believes the S&P 500 could be vulnerable to a roughly 15% drop from current levels based solely on dividend taxes.
Winners and losers
Clearly, though, taxes on dividends shouldn't affect every company equally. As Damodaran notes, all other things being equal, companies with higher dividend yields will need bigger valuation adjustments in order to bring after-tax dividend income back into equilibrium. For instance, with Frontier Communications (Nasdaq: FTR ) riding the wave of cash flow from its rural telecom business, it makes much larger payouts than most stocks -- and therefore shareholders will end up paying higher tax rates on more income than with most of their other investments.
But those concerns don't apply to all dividend stocks. On one hand, mortgage REITs Annaly Capital (NYSE: NLY ) and American Capital Agency (Nasdaq: AGNC ) are among the highest-yielding investments in the stock market, but because their dividends already fail to qualify for lower tax rates, they should remain unaffected by a dividend tax change. In fact, some investors might believe mortgage REITs would be more attractive if they didn't have the tax penalty they do now.
Moreover, investments that use partnership taxation rules to obtain tax benefits likely won't be affected as much as corporations whose shares have similar dividend yields. For instance, limited-liability company Linn Energy (Nasdaq: LINE ) and master limited partnership Energy Transfer Partners (NYSE: ETP ) both take advantage of favorable tax rules to produce high dividend yields, but much of their income already qualifies as return of capital and therefore isn't subject to taxation at dividend rates.
Too early to tell
The biggest uncertainty with regard to the possibility of a dividend crash is that no one knows how the government may resolve the fiscal cliff. Most lawmakers see it as a huge problem, but coming to consensus may prove impossible. For his part, Damodaran has his doubts, and he also thinks that risk premiums in the stock market don't reflect any possibility of an impasse that sends tax rates higher.
For at least the next month or so, you can expect no progress on this issue. But once the elections are over and the future becomes clearer, you may want to take steps to protect yourself from a dividend cliff that by then may be more likely to become reality.
Many retirement investors have turned to high-yielding Annaly Capital as an income producer, but is it a smart move? Read the Fool's premium report on Annaly and let our analysts help you decide for yourself. Click here to read on.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.