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Posted On: 12/13/2012
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One Investment Not To Drop When Fiscal Cliff Hits
By Nancy L. Anderson, CFP, Contributor to Financial Finesse
The fiscal cliff tax increase on dividend paying stock won’t affect most investors, which is actually too bad. Not because I am in favor of a tax increase by any means, especially on dividends and capital gains since they are tied to economic growth, but because more people aren’t taking advantage of dividend paying stocks. Stock investors in general have declined – only 54% of American investors reported holding individual stocks, stock mutual funds, or stocks in their retirement accounts in 2011 according to Gallup, a drop from 62% in 2001. Outside of retirement accounts, only 14.7% of investors hold mutual funds in taxable accounts today compared to 23.9% in 2001.
Despite the possible tax increase, investors may want to revisit investing in dividend paying stocks. As you know, the President and Congress are debating increasing the capital gains tax rate and changing the tax rate on dividends to fall in line with ordinary income tax rates so for those in the highest tax bracket, taxes on dividends could go from 15% to 39.6%. Taxes are even higher for taxpayers hit with the 3.8% surtax on net investment income if their modified adjusted gross income is over $250k ($200k if single). Even so, when the dust settles we can anticipate an increased tax on dividends. The fact is investing in dividend paying stocks may be a good investment move regardless of tax increases.
Relatively good income stream compared to current choices. What else can you do in this market environment? Interest rates remain low across the board so even a 2% yield on a dividend stock fund without taking appreciation into account beats the banks and credit unions now. On a portfolio of $250k a 2% dividend would pay $5,000 per year while 0.25% in a money market only brings in $625.
Better overall returns. Dividends can be a good defensive strategy since they made up 87% of the return of the S&P 500 from 2000 – 2010. They also enhance returns with a more aggressive strategy in a bull market. From 1990 – 2010, dividends made up 43% of the S&P’s total return. Even in time periods when capital gains taxes have been high, dividend paying stocks still rewarded investors with solid gains.
High-yield bonds may have run their course. Investors have flocked to high-yield-bond funds for income and total return. On average, high-yield-bond funds have returned over 12% (total return) so far this year compared with 2.8% in all of 2011 according to Morningstar. In terms of investing new money, some investors are concerned with the high share prices so the value may have been greatly reduced. With high-yield bonds becoming more volatile, this may not be a good strategy for the risk averse.
Invest in retirement accounts. You can still invest in dividend paying stocks inside your retirement accounts to defer the tax on dividends. If held in a traditional IRA or 401(k), all earnings, including those
from dividends, will be taxed at ordinary income tax rates. If held in a Roth IRA or Roth 401(k), the earnings are tax free if the account has been open for at least five years and funds are withdrawn at age 59 ½ or later.
Invest outside of retirement accounts. There are a whole host of reasons to invest outside of retirement accounts starting with long-term capital gains tax treatment on the appreciation (if held for at least one year and one day). Capital gains taxes may be going up, but they are still lower than ordinary income tax rates (even with a surtax on higher income earners). Retirement accounts carry a federal penalty for early withdrawal before age 59 ½ and many states follow suit. Investing outside of retirements accounts do not have additional tax penalties.
Unlike retirement accounts that limit early withdrawals to certain purposes such as medical expenses or funding college tuition for a family member, funds invested in non-retirement accounts can be used for any purpose. There still may be tax benefits in that you can harvest your losses against your gains – so when you have a loss, you can offset that against your gains essentially making those gains tax free. No one wants losses of course, but it certainly lessens the tax pain.
Inflation protection. While the dividend is nice, appreciation is essential to keep up with inflation. Dividend paying stock ETFs pay dividends anywhere from 1% to 5%, but also have the potential for appreciation. While many took a hit with the rest of the market in 2008 – 2009, some dividend ETFs have provided a total return over 10% per year the past three years. There are a wide variety of dividend ETF choices for investors. To learn more about ETFs, follow Forbes contributor Rick Ferri, or visit Morningstar.com.
If you own dividend paying stock outside of your retirement plan and want to take your capital gains hit now while the rates are lower, by all means, do it by year end. But don’t just throw out the baby with the bathwater and abandon this strategy next year. It may not be as profitable in a higher tax rate environment, but it’s still a tried and true strategy.
Nancy L. Anderson, CFP is the Think Tank Director and Resident Financial Planner at Financial Finesse, the leading provider of unbiased financial education for
employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals.
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This article is provided courtesy of Forbes.com. For more articles like this one on personal finance and
investing, visit their web site at Forbes.com.