At this point, we don’t even know if we are destined to go over the fiscal cliff and trigger the automatic tax hikes and budget cuts that are scheduled to go into effect, absent other congressional activity, on January 1. But the top tax rates seem pretty likely to be raised, and with them is likely to disappear the favorable tax treatment that dividends have enjoyed ever since the Bush tax cuts were passed more than a decade ago.
See also: Infographic: Gauging the fiscal cliff
During that period, dividends have been taxed at 15 percent — far below the top income tax rate of 35 percent, and the same as the capital gains rate. If we reach the fiscal cliff and nothing else intervenes, for people in the top tax bracket, the marginal (not the absolute) rate on dividends will revert from the current 15 percent back to 43.4 percent. Dividends would be taxed like ordinary income, so people in the 28 percent income-tax bracket would be taxed at the 28 percent marginal rate on their dividends as well. And any dividends accrued within IRAs or 401(k) plans would continue to incur no taxes.
There’s no guarantee this would happen. It’s likely that Congress will come up with some sort of compromise, lifting dividend rates to the same level as capital gains. Under any scenario, though, it seems that dividend rates are due for a hike.
Dividends have been a huge part of many equity investors’ strategies for a long time now. More than 40 percent of the total performance of the stock market in the U.S. over the last century has been derived from dividends. And that relationship is getting, if anything, stronger in recent years; investors who used to rely on bond returns for income have had to seek out other sources for consistent yield, now that bond yields are at historic lows.
Dividends have become nearly universal among large-cap stocks: More than 400 of the Standard & Poor’s 500 companies are currently paying out dividends. The payouts themselves, though, are relatively low. The overall payout ratio for the S&P 500 — the percentage of profits that get back to shareholders as dividends — is now at a record low of 29 percent, according to research conducted by the website the Motley Fool.
In anticipation of the tax hike, the market seems to be already punishing high-dividend stocks. Utilities has long been a sector characterized by a strong dividend payout, and over the past month, those stocks have just gotten hammered. From October 31 through November 23, the utilities stocks on the S&P 500 have dropped by an average of 10.4 percent, while the index as a whole has been up by 4.1 percent.
And the threat of confronting higher taxes on these dividends has pushed an inordinate number of companies into rushing those dividends out. According to the data firm Markit, 103 companies have already announced special dividends that will be issued before the end of the year, and they say the number could go as high as 123. The retail chain Dillard’s, for example, has traditionally paid its dividend out in January, stretching back for more than a decade, but now it’s paying a special five-dollar dividend in December. Walmart had earlier scheduled its dividend for January 2; now that’s been moved up to December 27. The casino operator Las Vegas Sands has also scheduled a one-time dividend to be paid out before the year ends.
These moves aren’t some kind of altruistic gesture on behalf of shareholders. The Sands is 52 percent owned by Sheldon Adelson, and the company’s $2.75 dividend will put an extra $1.2 billion in his pocket — and Adelson is definitely in the top tax bracket.
But this flurry of dividends shouldn’t be taken as a sign that companies will scale back their payouts in any significant way. Until bond rates begin to rise, investors seeking income will continue to turn to dividend stocks, which means that stocks will continue to offer dividends in an effort to make themselves attractive to investors.
On top of that, American corporations are still flush with cash. According to a recent report from JP Morgan, U.S. companies have roughly $1.5 trillion in cash or cash equivalents on hand. If that money isn’t going to be invested into new plants and production, it’s likely to keep flowing out in the form of dividends.
One thing to watch is just where that dividend tax rate falls: If it’s the same as the capital gains rate, or even lower, dividend investing will lose little of its luster. If for some reason it ends up higher than the cap gains rate, then maybe companies will figure out other ways to spend their money and attract investors.
Even then, dividends aren’t going away. Remember that figure: 40 percent of all stock returns over the past 100 years are on account of dividends. This percentage includes high-tax times, low-tax times, and everything in between. No matter where the tax rate lands, dividends are going to be with us for a long time.
For more from Tom Nawrocki, see: