You know the story. If Congress fails to act by the end of the year, then current income tax rates will expire and rates would rise for nearly everyone. All dividends would also be taxed as ordinary income, instead of the current 15% rate.
My opinion is that personal income tax rates will stay the same for most people. And even if dividend tax rates rise, the overall tax increase for most people will be small. What's more, investors who hold stocks in a tax-deferred account like an IRA won't see any change.
In the meantime, all of the panic surrounding the situation could be advantageous for income investors.
Dividend payers have been the darlings of the market in the past year. Historically-low interest rates and market uncertainty had even the most aggressive investors turning to solid dividend payers.
You can see that in the returns of many of the market's best-known dividend payers. AT&T (NYSE: T) is up 22% in the past year. Philip Morris (NYSE: PM) is also up 22%. And the SPDR S&P Dividend ETF (NYSE: SDY) -- which holds a basket of the market's steadiest dividend payers -- is up 13%.
This is a mixed blessing for us. On one hand, we've seen dividend payers gain as the demand for them grows. On the other hand, the yields on these securities have dropped as the prices increased.
A year ago, AT&T yielded 6%. Until just a few weeks ago, that yield fell to just 4.5% because of its soaring share price.
That's why I'm starting to get excited.
Although the market will celebrate if we avoid the fiscal cliff, dividend stocks may not join the party. Even if a budget deal is struck, the qualified dividend tax rate of 15% could very well rise. If that happens, then dividend stocks may lose their fair-weather investors -- and we could see share prices soften -- and yields increase.
We've already seen that happen once in the past month...
Main Street Capital (NYSE: MAIN) is a business development company (BDC). It lends money to mid-sized companies that can't easily access the public markets. As a business development company, Main Street is required to pass on the bulk of its profits to investors.
However, when the market sold off a few weeks ago, Main Street saw its price drop sharply in just a few days as fair-weather income investors dumped the stock.
That caused the dividend yield to spike from 5.9% to 6.6% in just days. (What's most interesting is that income from BDCs like Main Street Capital are taxed at ordinary rates. These investors wouldn't even be affected by increased dividend taxes.)
Since then, shares have rebounded, providing 10% in capital gains, along with locking in the higher yield. But Main Street is just one example of what happened among many dividend payers.
Action to Take --> There's no guarantee, but I believe the market will continue its knee-jerk fiscal cliff reaction, putting more pressure on dividend-paying securities in the short run. If and when that happens, I want to be a buyer and put cash to work in higher yields than I could have earned just a few months ago.