The $78 Billion Question Affecting Dividend Stocks Today

It’s one of the biggest questions facing income investors today: What does the “fiscal cliff” mean for dividend stocks?

The term “fiscal cliff,” coined last year by Federal Reserve Chairmen Ben Bernanke, describes more than $500 billion in automatic tax hikes, including higher dividend tax rates; and $100 billion in spending cuts, as well as a debt limit increase.

(For more information about what the cuts mean for dividends taxes, you can see my latest write-up on the subject here.)

These measures would start Jan. 1, 2013, unless Congress comes to a compromise during the current lame-duck session. The Congressional Budget Office estimates that allowing the tax cuts to expire and going off the cliff would shrink the economy by 0.5% — or $78 billion — throwing the United States into a mild recession. It would also increase the unemployment rate to 9.1% by the end of 2013 from 7.9% today.

Whether or not Congress intervenes, investors are likely to see higher taxes on dividends and capital gains. But the good news is several factors suggest higher tax rates may not trigger the selloff in dividend stocks that some investors fear.

For starters, about half of dividend-paying stocks on the market are held in tax-sheltered accounts, which aren’t affected by higher dividend tax rates, according to brokerage firm Stifel Nicolaus. Much of the rest is held by hedge funds and institutions, which aren’t affected by the expiring tax cuts.

If history is any guide, then your high-yield holdings should weather any dividend tax increase in the long term. Historically, dividend stocks underperformed non-dividend payers for about six months after a dividend tax increase, according to Ned Davis Research Group.

The worst of it came in the first three months after the tax increase, as non-payers gained about 50% more than payers during that time.

However, longer term, dividend payers far out-performed the broader market. During the past 40 years, S&P 500 dividend payers returned an average 8.7% annually versus just 1.5% for non-dividend payers, according to Ned Davis Research. So a short-term correction could prove to be a buying opportunity.

The long-term outperformance is driven by value. If dividend taxes were to rise, then fundamentally sound high-yield stocks will still look attractive compared with other income investments.

For example, the 10-year Treasury yields 1.6% right now. By comparison, a blue-chip stock like Verizon Wireless (NYSE: VZ) yields almost three times more at about 4.7%… and it offers a growing dividend versus the fixed-rate return of a bond.

Both would be taxed as ordinary income.

Action to Take –> We will likely see a compromise in the coming days, but questions remain about what that compromise will contain and what impact it will have on the economic recovery.

So, if you’re thinking about taking capital gains on a position, then now might be a tax-efficient time to do so.

The capital gains rate could increase from 15% today to as high as 23.4% come Jan. 1, 2013… you might be glad you took some profits early.