Unless lawmakers take some sort of action, the way that investors get taxed on their investment income will be a lot different when 2013 begins. In particular, higher rates could almost triple the amount of tax that certain investors pay on dividends.
Of course, it's anybody's guess as to whether the government will extend current tax breaks beyond the end of 2012. But even if lawmakers allow lower tax rates to expire, some quick, forward-thinking action from companies could be a welcome surprise for shareholders -- and could end up saving them a bundle in taxes.
Paying tax now to avoid paying more later
The fiscal cliff presents a golden opportunity for some unusual tax planning. Ordinarily, the smart move for taxpayers is to defer recognizing income as long as possible, because the longer you can avoid having to include that income, the longer you get to hang on to your money, earning income from its use rather than handing over its income-earning potential to the IRS early.
But the fiscal cliff's higher rates make it advantageous for many taxpayers to include income on their 2012 tax returns rather than putting it off until 2013. As a result, with future tax policy in limbo, many taxpayers are looking at ways to pull income into 2012, such as by realizing capital gains through selling appreciated stock and delaying deductions until next year.
Still, taxpayers can't control every aspect of their tax destiny. That's why an article from The Wall Street Journal over the weekend was particularly interesting. Columnist Jason Zweig suggests a novel approach that dividend-paying companies could use to help taxpayers out: Rather than paying dividends in early January, as many big companies do, making those payments a few days early would allow taxpayers to include them on their 2012 returns, potentially leading to big savings.
The Journal article points to a few companies, including General Electric (NYSE:GE) and Philip Morris International (NYSE:PM), that traditionally make payments during the first few trading days of the New Year. But you can find no shortage of stocks that regularly distribute payouts early in January. Automatic Data Processing (NASDAQ:ADP), for instance, typically pays out on New Year's Day every year. Reynolds American (NYSE:RAI) isn't quite as methodical, but you can count on seeing dividend checks within the first few days of January. If any of these companies choose to move their dividends forward, it could make their shareholders quite pleased.
In fact, some companies made moves similar to this two years ago, when favorable dividend tax rates first came up for debate. FedEx (NYSE:FDX) ended up making five dividend distributions in 2010, sneaking in what would usually have been its January 2011 payment into mid-December.
From the company's perspective, it makes almost no difference when a dividend gets paid. The company doesn't get a tax deduction for dividend payments, so it has no direct incentive one way or the other. As a result, given the huge impact it could have on shareholders, you'd hope that corporate managers would do whatever they could to reach the right result.
The problem, though, is that it's impossible for a company to make all of its shareholders happy. If certain shareholders have substantial income in 2012 but expect little in 2013, then they'll prefer a 2013 payment even if it imposes higher taxes on everyone. Perhaps more important, in the event that favorable dividend tax provisions get extended, then accelerating dividend payments into 2012 will lead to a needless early increase of income.
Will it happen?
Interestingly, with mutual funds, an IRS rule works in taxpayers' favor this year. Often, mutual funds don't make dividend payments until the following year, but tax law pulls those payments back into the current year for tax purposes. So mutual fund investors shouldn't expect any change this year. Only with individual stocks are payment dates actually respected.
At least for now, you shouldn't expect companies to commit to a particular course of action with respect to their upcoming dividends. Rather, many companies may well delay declaring dividends until after the election, at which point it should be at least somewhat clearer which direction tax policy is most likely to go in 2013 and beyond.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.