What Will 'Jurassic Cliff' Mean for Dividend Investors?

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If you haven't yet gotten the memo, taxes are going up.

The expiration of the Bush-era tax cuts (AKA the "Fiscal Cliff" or as we call it "Jurassic Cliff") on December 31, 2012 will increase tax rates on most ranges of ordinary income including long-term capital gains along with qualified dividends.

But higher taxes won't just affect wealthy taxpayers like some people think.

A report by the Tax Policy Center notes:

"Every income group would see taxes rise by more than 3.5 percent of pretax income. Upper income taxpayers would experience the largest tax increases, both in absolute terms and as a percentage of income. The top quintile would see its tax burden rise by slightly over $14,000 per tax return, almost 6 percent of pretax income. Taxpayers in the top 1 percent of the distribution would experience an average tax increase of over $120,000, slightly over 7 percent of their pretax income."

The Dividend Cliff

Assuming Jurassic Cliff becomes reality - and the odds are good - long-term capital gains will jump from 15% to 20% for all tax brackets.

But wait there's more: Dividends (SDY - News) from stocks will be hit even harder. Instead of owing just 15% as they do today, investors who receive dividends will be taxed at according to their ordinary income tax rates. Table 1 shows the damage. For example, individuals in the 25% bracket will get snagged for 31% versus 15% tax on dividends in 2013. Although certain tax brackets will completely disappear next year, what doesn't go away are higher tax rates across the board on all remaining brackets.

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Did I forget to mention that people earning $200,000 or more, and couples earning $250,000 or more, will also be hit with an additional 3.8% Medicate surtax on their investment income along with dividends? And if they make $1 million or more and they're unfortunate enough to live in a Neanderthal place like California, they'll get taken for another 13.3% in state taxes.  

A Simple Case Study

What kind of impact would that have on dividend investors? Let's look at the numbers.

Table 2 illustrates an investor in the 35% tax bracket with $100,000 invested in a group of dividend stocks yielding 4%. Our investor pays just $600 annually in taxes on those dividends in 2012, whereas they would pay $1,736 - or almost triple under new tax laws affecting dividends in 2013. Our illustration also includes the 3.8% surtax which begins next year on high-income investors.

The after-tax flogging is tremendous. Instead of yielding 3.4% after taxes, our investor reaps just 2.2%.

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Debunking a Big Myth

The negative impact of higher dividend taxes are not overblown, as some have ridiculously suggested. I've even heard some experts ignorantly argue that tax increases on dividends won't affect investors that own dividend paying stocks inside tax-deferred retirement accounts like IRAs and 401(k) plans. This is a cute theory that's simply not true.

Because of rock bottom interest rates, the investing masses have piled into dividend stocks (DVY - News) in search of higher yields. This is the same crowd that has bid up prices for dividend stocks and they could very well drive them down by selling. And lower valuations for dividend stocks will impact all classes of equity investors - regardless of whether they hold their stock in a tax-deferred account or not.

Why would a person keep money in a dividend paying stock with an after-tax yield of less than 3%, when they can invest elsewhere with higher after-tax yields? Under 2013 tax rules, the value of dividends generated from dividend stocks is not as valuable as it was under previous rules. This also suggests that dividend stock prices aren't worth as much.

Solutions

Unfortunately, buying even more dividend paying stocks (VIG - News) isn't the solution to the tax tsunami that awaits income investors. If traditional methods for producing income are being penalized by the government via higher taxes, the only way to replace that lost money is by finding it somewhere else.

Our $100,000 all ETF IncomeMix Portfolio  has generated just over $9,400 in monthly income year-to-date by combining both dividend income and money from covered calls. Our aggressive income approach is helping investors to discover lost money they never knew about. And the expense ratio average for this portfolio is 0.18%, which is five times less compared to the funds.

Bottom line: Aggressive measures to keep your current income from being devoured by oppressive tax rules is an absolute must. Or as Dorothy said to Toto: "I have a feeling we're not in Kansas anymore." 

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