In this period of uncertainty the average person can become overwhelmed by the plethora of information and speculation regarding policy changes on taxes and investments. Political pundits/extremist on both sides use grandiose terms and elaborate stories in hopes of swaying public opinion or to garner higher ratings.
If you listen to one side you would believe that the filthy rich are the only ones that have benefited from the historically low dividend tax rate. The opposition will paint a picture of Uncle Sam seizing Grandma’s house because she can’t afford the taxes on the dividends from her five shares of General Electric stock.
We don’t have a crystal ball, but we hope to shed some insight on dividends and taxes to avoid some of the confusion:
What is the tax rate on dividends?
Qualified dividends are currently taxed at a maximum of 15%. According to Ibbotson/Morningstar the 40-year average maximum rate on dividends is 44.6%. In addition, the current maximum long-term capital gains rate of 15% is much lower than its 24.7% 40-year average. As a taxpayer you should know the difference between a qualified and non-qualified dividend.
How much are taxes going to increase?
President Obama has asked Congress to keep capital gains and dividends tax rates at 15% for individuals with incomes below $200,000 and to increase those rates to 20% for those over the $200,000 threshold ($250,000 for couples).
As we all know, asking Congress for something and actually getting it are two different things. Only time will tell where the rates end up, but it is pretty safe to say they will increase and more than likely still be below historic rates.
Why are dividends important?
For some, dividend-paying stocks are the only way to go during certain time. It’s hard to argue their power. From 1926 to 2008 the S&P 500 average annual return was 9.8%. Out of that return 4.2% came from dividends and 5.6% came from capital appreciation.
If you buy a stock at $50 per share and the stock pays a $2 per share dividend, your current dividend yield is 4%. In other words, if the stock price does nothing for one year and pays its dividend, you will have a 4% return on your money. This is why when stock prices are lower their dividend yield is higher and much more attractive.
What should I do given the pending changes in tax rates?
Its best to make your decision on many factors and not in a vacuum. Are you going to voluntarily stop working if income tax rates are going up in order to avoid a higher rate? Probably not. You shouldn’t ignore your current tax situation when building your investment portfolio, but you shouldn’t make drastic investment decisions based on pending or current changes in the tax code. As we mentioned in a previous post, your financial team should work together in helping you make these types of decisions.