Investors, dividend-paying companies both at risk

Apr 24, 2012, 8:05 am EDT | By Jeff Reeves. Editor of InvestorPlace.com

It’s just about a week removed from Tax Day, and many investors have their capital gains taxes and dividend taxes from 2011 fresh in their minds. However, if you’re sensitive to investment taxes, then future tax rates should be much more important to you than previous payouts because if Congress doesn’t act, you could be paying a lot more on your investment and dividend income in the near future.

Tax cuts on dividends and capital gains are set to lapse at the end of 2012, meaning that by 2013, you could be paying a nearly 40% tax on some of this income!

That’s if Congress doesn’t act, of course.

Some investors aren’t sensitive to taxes on their portfolios if they use a 401k or a traditional IRA, in which transactions within the account are executed tax-free. But this is a monumental issue in taxable accounts.

I recently caught up with Keith Voight of the Edison Electric Institute to talk about the threat of higher tax rates, particularly on dividend investors. The Edison Electric Institute and its member electric utility companies have an obvious connection to the issue since any income-oriented investor should know that publicly traded utility stocks are some of the most popular and reliable dividend plays on the market.

Edison, along and a wide variety of organizations and companies with a stake in the issue, are sponsoring a national campaign called Defend My Dividend to raise awareness about the issue.

Here’s what Keith thinks you need to know:

Q: Give me a bottom line for investors: What is their current tax rate on long-term investments and dividends now, and what will it become if Congress doesn’t act?

A: Federal tax rates on dividend income were temporarily reduced in 2003, when Congress passed the Jobs and Growth Tax Reconciliation Act. The 2003 law capped the tax rates on dividend income at 15%. Taxpayers in the 10% and 15% tax brackets had their tax rate on dividend income lowered to zero. The 2003 move also cut the maximum tax rate on long-term capital gains from 20% to 15%. These tax rates on dividend income and long-term capital gains were temporarily extended in 2006 and again in 2010.

Today’s federal tax rates on dividend income and capital gains are set to expire on Dec. 31, 2012. If Congress and the president don’t act to stop a dividend tax hike before then, the maximum individual federal tax rate on dividend income in 2013 will soar to 39.6%. The top tax rate on capital gains, meanwhile, will rise from 15% to 20%. Beginning in 2013, an additional 3.8% Medicare tax will also be added on both the dividend and capital gains tax rates for households earning more than $250,000, or $200,000 per single filer.

Q: Many are speculating that Congress will most likely pass a short-term extension to avoid an election year showdown. What happens if it doesnt?

A: Tax rates on dividend income should be kept low and on par with those on capital gains. This will help the tens of millions of Americans who own dividend-paying stocks either directly or indirectly through mutual funds to keep more of their quarterly dividend checks. The lower rates also support the value of stocks held in life insurance policies, pension funds, 401k plans or individual retirement accounts.

Raising tax rates on dividend income and taxing dividends at higher rates than capital gains will hurt consumers in another way as well. Stock market investors will face lower tax rates if they move from investing in companies that pay dividends to buying growth stocks that typically don’t pay dividends or have a low dividend payout ratio. This has the potential to lower the dollar amount (percentage rate) by which companies ordinarily increase their dividends and could reduce the stock value for all shareholders.

As a result, Americans who own dividend-paying stocks will take a double hit not only will they be paying higher taxes on their quarterly dividend checks, but they will also likely see the value of their stocks fall. And because the market is forward-looking, the fear is that their stock prices will fall sooner rather than later. If this happens, all taxpayers who receive dividend income would be affected, regardless of their income.

Q: With interest rates at rock-bottom levels, dividend investing is one of the few places where seniors can find regular income for retirement. Do you think there’s a misconception about who is paid dividends, and what kind of investor is attracted to stocks that pay quarterly distributions?

A: In fact, taxpayers age 50 and older file almost two-thirds of all tax returns with qualified dividend income, according to data from the U.S. Internal Revenue Service. And taxpayers age 65 and older file close to a third of these returns.

Because interest rates are at record-low levels a policy the Federal Reserve is likely to keep in place through 2014 many of these seniors and other investors are looking at dividend-paying stocks as a safer alternative to other investments. According to a February 2012 study by JPMorgan, total dividend distributions jumped from $340 billion in 2008 to about $680 billion in 2011; another big jump is expected in 2012. The study cautions that “the current premium that investors are placing on dividend-paying stocks may be negatively impacted by a change in tax rates.”

Q: You represent Edison Electric Institute as one group that is behind the Defend My Dividend movement which is no surprise, since utility stocks are some of the biggest dividend payers on Wall Street. Obviously investors don’t buy utilities because they expect them to grow revenue and profits at a pace like Apple. Do you think a dividend hike could significantly affect how investors perceive publicly held utilities and other low-growth sectors?

A: Keeping tax rates on dividends low and on par with those on capital gains is particularly important for the electric power industry. Electric utility companies paid out 59.2% of their earnings in the form of dividends last year. The next highest payout ratios among U.S. business sectors were consumer staples at 44.6%, and industrials at 31.3%.