The Impact of the New Dividend Tax
- June 24, 2010
- Dividend Investing, Dividend Stocks, High Yield Dividend Stocks
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Yesterday the Democrat-controlled Senate voted down a proposal to make the 15% tax rates on dividends and capital gains permanent.
The motion had been proposed by Senator Jim DeMint (R-SC), but was defeated by a vote of 57-40.
The 15% dividend tax rate was implemented by former President Bush as part of his middle-class tax cuts in 2003. Unfortunately, that tax cut was only temporary and is now set to expire at end of this year. If that is allowed to happen, dividend income will then be taxed at investor’s marginal tax rate. For some investors this could push their tax rate from 15% all the way up to 39.6%.
For dividend investors the impact of the new dividend tax will be drastic. The capital gains tax is set to only increase to 20%.
The most frequently cited research has shown that the stock market returns about 12% over the long term. However, dividends account for about 40% of the market’s total return. Let’s take a look at how the new dividend tax will impact investor’s after-tax returns using the long-term market assumptions of a 12% return (composed of 5% from dividend income and 7% from stock price gains).
Current Rate
5% dividend income is taxed at 15% rate giving an after-tax return of 4.25%
7% capital gains is taxed at 15% giving an after-tax return of 5.95%
An investor’s total after-tax return is 10.2%
New Tax Rate
5% dividend income is taxed at 39.6% rate giving an after-tax return of 3.0%
7% capital gains is taxed at 20% giving an after-tax return of 5.6%
An investor’s total after-tax return is 8.6%
The end result is market returns that are 16% below current levels.
Of course the impact is even more significant for investors that rely on dividends as their primary source of income.
Take for example an investor that has built a dividend portfolio that receives $20,000 in dividend income each year. Under the current tax rate, that investor will have $17,000 in after-tax income. However, that amount could drop to as low as $12,080 next year. That is an amazing 29% drop in income which many could find difficult to replace.
Companies that pay dividends are also concerned about the potential tax hike. Many utility stocks, which typically offer higher dividend yields, have joined together to launch a grassroots campaign to retain the current tax rates. You can visit their website www.defendmydividend.com for more information.
Investors don’t need another incentive to sell stocks!
