Thursday, May 20, 2010

Dividends in the Context of Taxation Environment

One the benefit that dividend investors have is lower tax percentage (i.e. 15%) on qualified dividends. In case of lower tax brackets, the qualified dividends are not even subject to taxes. In 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act. One of provision in this law was to reduced the tax rates on certain dividends (known as qualified dividends) to 15% for the highest income earners. Furthermore, this provision are to expire at the end of 2010 if Congress fails to renew or modify. So far, it has not been extended.

Imagine that Berkshire had only $1, which we put in a security that doubled by year-end and was then sold.

Image further that we used after-tax proceeds to repeat this process in each of the next 19 years, scoring double each time

At the end of the 20 years, the 34% capital gains tax that we would have paid on the profits from each sale would have delivered about $13,000 to the government. We would have left with about $25,250. Not bad.

If, however, we made a single fantastic investment that itself doubled 20 times during the 20- years, our dollar would grow to $1,048,576.

Were we then to cash out, we would pay 34% tax of roughly $356,500 and be left with about $692,000.

--- Warren Buffett in Berkshire’s 1989 annual report.

This is not directly applicable to dividends. But the reason I bring this up, is it highlights the importance of taxation in growth of investments over time.

In the event that Congress does not take any action, this existing law will expire and taxes will be reverted back to pre-2001 level. In accordance to pre-2001 level, the dividend income will be treated as ordinary income. So for many, depending upon their tax bracket, this could mean 30% or even 40% tax on dividends.

With our government under debt and running large deficits, it appears that our President may take this as an opportunity to raise tax. If not to pre-2001 era, then at least to some higher level. The proposal is to raise dividend income tax to 20% for married couples earning $250,000 or more, while keeping it same at 15% for lower income tax bracket.

These increase in dividend taxation may seem like a small increase. However, in my view this is likely to affect the macro-environment around dividends, for example:

  • Will it affect stock valuations? Increase in dividend taxes for large shareholders will result in reduced returns. To increase their returns, they may likely pay less for buying a stocks, thereby affecting valuations. In addition, it is also likely that they may start influencing management about payout ratios.
  • Will it affect share buybacks? It is also likely that share buyback paradigm may get a boost because it is believed to provide a floor. Large shareholders would tend to prefer higher stock prices when compared to dividends.
  • Will cash flow into IRA? If we combine all taxation (dividends, capital gains, etc), then using tax deffered account becomes more attractive. It is likely that financial advisors will start recommending dividend companies in IRA account rather than individual portfolios.

To small individual investors like me, I does affect a bit, but not by a significant amount. The only impact is slowing down of dividend reinvestment which will not be visible immediately. One could argue that similar taxation, pre-2001 era, did not affect the dividend policy of good companies. That's true to a certain extent. However, we need to realize that US companies may not have similar earnings growth as seen in pre-2001 level. Therefore, it is likely that the environment surrounding dividends, the motivation behind, etc, may get affected.

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