For the investor in funds that generate above average dividends, such as equity-income or value funds, key questions going forward are what will the tax on dividends be after Congress most likely reforms the tax laws in the coming year, and what impact will those reforms have on such funds. In order to make that determination, it is first necessary to analyze the various options under consideration and their likelihood of becoming law. This is critical to a sound analysis. At this stage, five different outcomes for the tax on dividends have been put on the table and subject to public discussion:
- Reverting to the tax rates in effect prior to the enactment of the Bush tax cuts in 2001, the option provided for under current law;
- Extending the Bush tax cuts for all taxpayers except couples making more than $250,000 per year or individuals making more than $200,000 (the President's proposal);
- Increasing the tax on dividends for all taxpayers from 15% to 20%, as Senate Democrats have proposed;
- Implementing a progressive tax on dividends from 15% to 22.5%, favored by some senators; and
- Taxing dividends as ordinary income while lowering the marginal rates, the principal Simpson-Bowles commission alternative.
1. Reverting to Pre-Bush Tax Rates
If the pre-Bush tax law is reinstated, dividends will be taxed at ordinary income rates. The marginal rates would range from 15% to 39.6%.
President Obama and Congressional Democrats, however, have indicated their support for only continuing the Bush tax cuts for couples with less than $250,000 adjusted gross income, and individuals with less than $200,000. Congressional Republicans have indicated their desire to extend the Bush tax cuts for all income earners. If Democrats and Republicans are unable to compromise their difference on this issue, tax rates will automatically revert to the pre-Bush levels at the end of the year, with the exception that incomes above $250,000 will be subject to an additional 3.8% tax on dividends adopted as part of the Affordable Care Act (Obamacare).
In my opinion, while there may be some short period where taxation temporarily reverts to pre-Bush levels, given strong Democratic and Republican opposition to reverting to those tax levels for incomes below $250,000, most tax cuts for these filers will likely be restored.
2. President Obama's Proposal
As mentioned above, President Obama in February proposed retaining the current dividend rate of 15% for couples with adjusted gross incomes of less than $250,000. For taxpayers above this threshold, he would revert to the pre-Bush tax rates. For couples, the highest marginal tax rates would be 36% for income up to $388,000 and 39.6% for any income above that amount. So if the President's proposal is adopted, the highest marginal tax rate for dividends would be 43.4% (39.6% plus 3.8% under Obamacare).
While numerous articles in the financial press have cited the 43.4% figure as reason to sell off or be concerned about dividend stocks, it is highly unlikely to me that the President's proposal will be adopted. Simply put, the proposal would appear to be irrational.
To illustrate, if the proposal were enacted, a couple with income of $249,999 or less would pay a flat 15% taxes on all their dividends; but a couple making $250,000 would be subject to progressive taxes up to 36% on all their dividends and earned income, in addition to the 3.8% Obamacare tax on dividends, for a tax on dividends of up to 39.8%. For income above $388,000, taxpayers would be subject to the highest marginal rate of 39.6%, plus 3.8% on dividends, for a tax on dividends of up to 43.4%. Such a differential between those making above and below $250,000 would result in a tax on dividends which is both radical ("cliff like") and a significant departure from more gradual scaling up under historical progressive tax laws. It appears arbitrary and more punitive than progressive. Congress is unlikely to enact such a proposal.
In fact, last July, in the context of voting on a partial extension of the Bush tax cuts, Democrats in the Senate refused to go along with the President's plan. While they passed legislation extending the Bush tax cuts for incomes below $250,000, they refused to adopt the President's dividend proposal for taxpayers with income above the $250,000 threshold. Instead they adopted a flat 20% tax on dividends for all taxpayers.
When Republican Senators and Representatives are now added to the decision making mix, it is even less likely that Congress will adopt the President's plan. It may well be that the President made this proposal on dividends simply as a bargaining chip to exchange for increased marginal rates on earned (i.e. not investment) income for incomes above $250,000.
3. Senate Democrats' Proposal
The 20% tax on dividends passed by the Senate Democrats last summer would appear to be a plausible compromise. For those with income above $250,000, the tax rate on dividends would be 23.8%, including the Obamacare tax.
For Republicans to agree to this, however, they would have to violate their "no tax increase" pledge both in terms of revenues and rates. This would be a major step, especially considering the continued rejection of tax rate increases by the Republican leadership following the election. For Democrats, it would mean increasing dividend taxation rates for all taxpayers, a proposition which some have rejected as raising taxes on the middle class. In order to achieve tax reform, such compromises will likely be necessary.
4. Progressive Dividend Tax Option
Democratic Senator Ron Weyden and Republican Senator Dan Coats have proposed a progressive tax on dividends ranging from 15% to 22.5%. Senator Kent Conrad, the Chairman of the Senate Budget Committee has indicated interest in such a proposal, which would be consistent with progressive tax scales on earned income.
Many people mistakenly believe this consists of a single plan. In fact, the plan contains a variety of options for changes to the tax code. The first option, which is designated as "the Chairman's draft," would create three tax brackets, 12%, 20% and 27%, eliminate tax deductions, and tax dividends at the same rates as earned income.
President Obama, when interviewed for Bob Woodward's Price of Power, indicated that he did not believe Congress would be willing to eliminate all deductions, and that therefore, the Simpson-Bowles plan was unrealistic. It does appear that eliminating all deductions for mortgage interest or state taxes would face such resistance that such a law is unlikely to be enacted.
So What Will Be the Final Outcome?
The uncertainty about how this will play out was emphasized at a recent meeting of the President and 12 CEOs of leading American corporations, including Lloyd Blankfein of Goldman Sachs. Based on interviews conducted by POLITICO on November 28th, the report concluded: "The executive and others who attended or were briefed on the White House meeting added that the president was also adamant about having dividend and capital gains tax rates rise from their Bush-era levels but was not doctrinaire about exactly where they should wind up." Obviously, the executives pressed for limited, if any increases, and the President left open options less severe than feared 43.6% top rate.
Dividend Stocks Remain An Attractive Investment Option
Needless to say, there are great uncertainties about what taxation on dividends will look like once the current disputes over the budget and tax issues are resolved. It is more likely, however, that the ultimate scheme will be closer to the 20% plan passed by the Senate Democrats last summer, or the Weyden-Coats progressive tax plan, than to the plan proposed by President Obama, reversion to pre-Bush tax levels, or even the main Simpson-Bowles option.
Looking beyond what the ultimate structure of taxation on dividends will be, there are a number of reasons that dividend stocks, and therefore mutual funds that focus on such stocks, will remain attractive investments even if rates go up. By comparison with money markets and CDs, and even many bond funds, the return on dividend funds is much more advantageous. Further, as the Baby Boom brings on more retirees, the desirability of dividends for income flow will likely become more attractive.
For the mutual fund investor, the bottom line is that any flight from equity-income and/or value funds and many of their underlying dividends stocks, has been based on the likely unrealistic expectation that tax rates will revert to pre-Bush levels. As negotiations intensify over coming weeks, those fears are likely to be magnified and the funds may be driven lower. The prudent investor, however, should not abandon these positions, but should consider adding to them on any further drawbacks.