Individuals Directly Saved $274 Billion on Dividend Tax Cut, But Payback Time Is Coming

Posted by: Howard Silverblatt on August 23, 2010

I am estimating the qualified dividend tax cut savings from 2003 until year-end 2010 have saved direct individual owners of S&P 500 issues $140.70 billion
For the full universe of U.S. domestic common stocks I am estimating another $133.77 billion in savings, for a total of $274.47 billion over the 8 year period

In four months a series of temporary tax cuts initiated under former President Bush in 2003 will expire, resulting in tax rate increases for individuals for capital gains (holdings of at least one-year) and qualified dividends. The scheduled automatic increase for long term capital gains will increase from a maximum of 15% for individuals to a maximum of 20%, with the maximum dividend tax rate increasing from 15% for qualified dividends to 39.6% for all dividends. Starting in 2013 Medicare tax of 3.8% (brings the rate to 43.4%) will be added to high-income individuals. The U.S. Congress is planning on an expanded discussion on tax issues and rates when they return from their summer recess in September. However with major elections in November, and publicly announced plans varying widely, even within the same political party, a potential for no change exists, in which case rates automatically change at year-end. Complicating the situation are pay-as-you-rules, sixty vote requirements, and the possibility of a lame-duck post-election congress, all of which adds up to a situation more difficult to predict than the market.

Any large increase in capital gains could spur investors to sell stocks, therefore avoiding higher rates next year. Under current regulations investors could repurchase the shares they sold at a profit, if they wished, at the same time. The result would be a short-term gain for the U.S. Treasury via increased tax revenue, which is attractive to many in congress as they determine how to pay for existing and planned programs.

The much steeper dividend increase is of concern to investors. Higher dividend tax rates to individual investors would require investors to ‘rethink’ their net income alternatives. However, given the current low interest rate environment on bank certificates and fixed income instruments, the additional tax may not force many to change investment strategies. Corporations may also review their shareholder return policies, given that investors will keep less of what the company distributes as dividends, with additional share buybacks being a potential winner. Special dividends, especially tax differed stock distributions or those classified as a return of investment have been openly discussed, but little has occurred as of yet.

Several items come to mind:
Americans have shown a strong tendency for tax avoidance, therefore capital gain might need to rise more than the scheduled 20% to entice them to pay today for tomorrow’s gains. Brokers and advisers however will most likely (and should) crunch the numbers and present it to investors.
The change in tax rates is an excellent opportunity to review portfolios and make strategic changes; note that inheritance tax returns next year (die now or pay later).

The 39.6% dividend tax rate still leaves stocks competitive with CDs and treasuries, which leaves the investor with the same risk-reward tradeoff question, just at a different level.
With companies now issuing more debt (partially to refinance at lower rates, compared to maturity schedules), and investors ‘appearing’ to accept some risk, lower grade issues could become more attractive to income dependant investors - the very group which should be avoiding risk.

Buybacks are typically a short-term win-win situation. The added buying pushes the stock up (even if it is declining it should reduce the speed), earnings per share benefits almost immediately via the lower quarterly average share count, investors have a larger stake in the remaining company, and from a company’s views the company still owns the stock which can be reissued, compared to a dividend, where if you send me a check I will cash it and expect another one next quarter.

Taxes paid to protect built up profits may be viewed as ‘painless’ by congress.
Nothing is certain in politics and almost everything is up for grabs:
Grandfather capital gains rates if held from a specific time (ie: purchased prior to 9/2009)
Reduced tax rate for initial dividends, in addition to normal tax schedule based on income (ie: first $1,000 exempt or taxed to 15%)
Change in recognition of dividends enrolled in Dividend Reinvestment Program (this would defer taxes)

I would expect considerable discussion on tax policy, along with all the sound bits, political spin and posturing, both before and after the November election. Investors need to keep an eye on taxes, but focus on the specific investments; paying tax on a gain means you have made a profit, and earning 0.10% annual is better than taking a loss.