Now that the presidential race is set (Romney/Ryan versus Obama/Biden), we can expect the campaign rhetoric over extending the Bush-era tax cuts to hit fever-pitch levels.
In fact, the chatter over the so-called “fiscal-cliff” is already picking up, especially in regards to its impact on dividend investing.
If nothing is done, the dividend tax rate is set to skyrocket from 15% to 43.4% for the nation’s highest earners. And that’s prompting fear-filled headlines to crop up everywhere, like this one from Barron’s: “Surging Dividends Face Growth, Fiscal Cliff Risks.”
Please don’t go get your panties in a bunch over this issue, though. Fear seldom leads to smart investment decisions. And in this case, it’s severely misplaced.
Truth is, the uncertainty surrounding the potential dividend tax increase could provide a windfall for dividend investors. Here’s how…
Get Ready for a Flood of Special Dividends
As we know from the the debt ceiling debacle, Congress loves to procrastinate. And coming to a compromise on tax rates promises to be another last-minute affair.
Ultimately, as I’ve written before, I’m convinced “all the worry is going to amount to nothing more than just that – a whole lot of worry.” There is no way Congress is going to increase the dividend tax rate by almost 30 percentage points.
I’m even more confident of that now that the Democrats are stepping out of line with the President and softening their stance. As my colleague at Dividends & Income Daily, Ryan Anders, noted Monday, “The party has instead drafted legislation to keep the dividend tax rate from rising above 23.8%, which is about half the rate Obama proposed earlier in the year for those in the highest bracket.”
Here’s the problem: Corporations can’t bank on Congress preventing the dividend tax rates from skyrocketing. Instead, they have to act with the worst-case scenario in mind – a tax increase. And that means shelving any plans to increase dividends in 2013 in favor of a special dividend in 2012.
That’s right. I’m convinced companies are going to start paying out another round of dividends this year… or “fifth quarter” dividends, if you will.
They can certainly afford it, given their record cash balances and profitability. Or as Standard & Poor’s Howard Silverblatt notes, an extra dividend “should have only a minor impact on their year-end ratios and liquidity.”
Yet, for investors, the timing of the payment could be extremely important and advantageous. As long as the dividends are paid in 2012, investors are guaranteed to keep 85% of the payout.
Once 2013 hits, though, the payout ratio could drop to 76.2% based on the Democrats’ latest proposal – or 56.6% if the Bush-era tax cuts expire.
Plus, it would help corporations avoid a public relations nightmare by opting for a special dividend instead of a dividend increase in early 2013. As Silverblatt says, “[The company] better have a really good reason for me only getting $0.57 in January instead of $0.85 in December.” Indeed.
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Add it all up, and special dividends represent a win for companies and investors alike. And we’re already seeing signs of companies waking up to this reality…
- On July 26, Choice Hotels (NYSE: CHH) announced a special dividend of $10.41 per share to shareholders of record as of August 20, 2012.
- On August 2, Limited Brands (NYSE: LTD) announced a special
dividend of $1 per share – in addition to its quarterly dividend of $0.25 per share – which will be paid to shareholders of record as of August 23, 2012.
- On August 13, HollyFrontier Corporation (NYSE: HFC) announced a special dividend of $0.50 per share, in addition to its regular quarterly dividend of $0.15 per share, which will be paid to shareholders of record as of August 27, 2012.
Taking the Naysayers to Task…
Now, some pundits completely disagree with me on this topic. They contend dividend taxes are going (way) up, and, in turn, companies are simply going to stop increasing – or even paying – dividends. Instead, they’ll put the money toward share repurchases.
After all, doing so would return money to shareholders in a more tax-efficient manner, since the capital gains tax rate would be lower than the dividend tax rate.
I’ll concede that sounds like a perfectly reasonable argument. But tune in to Dividends & Income Daily on Thursday – our new, forever free newsletter – at www.DividendsandIncomeDaily.com. I’m going to shoot gaping holes in that argument. And I’m going to do it with the help of reams of historical data, which show that corporations don’t behave in lockstep with tax policy when it comes to choosing between dividends or share repurchases.
Bottom line: Fears over a dividend tax rate hike are completely overblown. However, the inability of Congress to compromise quickly could encourage companies to act by paying out special dividends before the end of the year. For once, we might actually benefit from Congress’ inability to act. So don’t bail on your dividend stocks. You could be in store for a year-end bonus.
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Ahead of the tape,