Don't let higher taxes keep you away from dividend-paying stocks

Green figure stacking cubes with percent signs on them

Unless Congress acts, tax rates on dividends are set to rise in 2013.

But even if rates increase, dividend-paying stocks will remain one of the few places where many of us can turn to find a decent yield.

Sure, increased taxes will reduce your earnings, but if you pick the right stocks, your investment still stands to pay more than the 1.11% APY an average 5-year certificate of deposit earns today. (Your CD earnings, of course, are also taxed.)

Here's what's set to happen, thanks to some expiring tax breaks, part of what economists and politicians have called the "fiscal cliff."

Most investors pay a dividend tax rate of between 0% and 15%. Beginning next year, dividends are scheduled to be taxed at standard income tax rates.

This alone is a substantial hike. But it's made worse because there's a looming income tax increase as well, as the Bush-era tax cuts are set to expire.

Income -- and dividends -- will be taxed at a rate of between 15% and 36% for most earners. (Remember, if your dividend-paying stocks are held in a Roth IRA, you still won't pay any taxes.)

Those in the current 15% tax bracket will see the biggest impact. With the change in income tax rates, they will see their qualified dividend tax rate jump from 0% to a whopping 28%.

That means every $1 they earn in dividends will be worth only 72 cents after taxes.

For the wealthy, the top rate on most dividends will jump from 15% to more than 43%, which includes a new Medicare tax on investment income for top earners as part of the health-care overhaul passed in 2010.

Could this endanger dividends as a way to reward investors? It could have an impact.

Because investors have struggled to find decent yields, more companies have been initiating dividends as a way to raise capital and reward shareholders.

In 2011, a record 22 companies in the S&P 500 started paying dividends.

Higher dividend taxes could prompt companies to look to return more value to shareholders via capital gains.

They often do this through stock buyback programs.

(Capital gains aren't safe from the tax man, either. Rates are set to rise here as well, but capital gains still will be taxed at a bit more than half of what dividends are scheduled to be taxed.)

There's still time for Congress to act to prevent these hikes -- or at least soften the blow.

Indeed, it's hard to imagine lawmakers will do nothing to reduce the fall from the "fiscal cliff," a combination of spending cuts and tax increases set for 2013. The nonpartisan Congressional Budget Office says if Congress fails to act, these changes will almost certainly plunge the country into a recession.

Even if politicians fail to act responsibly, we don't want their inaction to convince you to pass on buying dividend-paying stocks or, even worse, to sell the stocks you already hold.

Here's why.

Even if you're paying a 28% tax on your Verizon dividends (this stock has a yield of 4.6%), you'd still be making more than double the after-tax return you would on the best-paying CDs.

Yes, CDs and savings accounts are government-insured, but solid stocks still can offer a relative level of security in these turbulent times.

Companies like Exxon Mobil, Proctor & Gamble, Pfizer and Coca-Cola are highly unlikely to go bankrupt tomorrow or see a 30% decline in share price.

Even if growth isn’t always that exciting, decent dividends mean you can still earn a return when the stock is flat.

This is good not just for long-term investors but for those looking to park some cash for a few years.

Leave a Reply

Your email address will not be published. Required fields are marked *