How a Tax Hike for Dividends will Affect your 401K

The current class warfare being stirred may have collateral damage well beyond the targets.  While at first it seems like a good idea to raise taxes on dividends (after all, who but an avaricious, Scrooge McDuck-types would collect dividends?) raising dividend taxes may affect everyone who has shares in a 401K or even a pension plan.

Some background:  As part of the tax cut package of 2003, dividend tax rates were lowered to a flat 15% rate.  Before this point they were taxed as normal income, with rates as high as 38%.  The rationale behind having lower dividend tax rates than ordinary income rates is twofold:

1)  Lower rates encourage investing, which in turn lowers the cost of capital, thereby creating economic growth. 2)  The income received by investors is already taxed at rates up to 35% by the corporate tax.

Currently there is a movement to raise those rates back to where they were before 2003.  This would mean that those who pay the highest tax rate would see their taxes on dividends rise to 38% again (or perhaps even higher, depending on the political mood).  Those paying lower rates – mainly the middle class – would tend to pay more than they are now but would pay a lower rate than the highest earners.  For example, if you are in the 20% tax bracket you would pay 20% on dividend income.

So this would just mean that people would pay a bit of a higher amount on dividends, right?  Well, not exactly.

You see, when an investor buys a stock, the price he is willing to pay depends on the relative return of the investment when compared to other, less risky investments.  For example, if a bank account is paying 3% and investment grade bonds are paying 6%, investors might not buy stocks unless the potential return is at least 9%.

Determining the return for a stock is more complicated than determining that for a bank account.  One does not just look at the current dividend, but at what the dividend may be in the future.  Because the more a company earns, the higher a dividend they can pay, stocks tend to increase in price as the earnings rise and fall when they fall.  A stock that pays a $1.00 per year dividend now, but may see earnings double over the next several years, may see the payout of the dividend double as well.  If the stock price is currently $20 per share, the current yield would be 5% ($1.00/$20).  If the dividend is doubled, however, and one bought in now at $20, one would be receiving an effective dividend of 10% ($2.00/$20) when and if the dividend were raised.  The price of the stock may double as well over that time, but that does not affect the effective yield the investor who bought in at $20 is receiving.

Raising taxes on dividends lowers the effective return.  If you receive a 10% dividend but the dividend is taxed at 40%, you are only receiving a 6% dividend after taxes.  The effect of raising taxes on dividends is therefore to make future dividends less valuable and thereby lower future returns.  Investors react to this by reducing the price they are willing to pay for the stock currently, which will cause the price of the stock to drop.

So that will only affect dividend paying stocks, right?  No, remember that the price investors pay isn’t based entirely on current dividends, but on potential future dividends as well.  This is why investors are willing to buy stocks that pay no dividend at all.  They are hoping that eventually the stock will start paying a dividend, and they will then receive a really great return for the amount they originally invested.  All stocks will therefore drop in price, not just those that pay a dividend (although dividend paying stocks may be hurt more since investors may feel that tax rates may be lowered in the future before the stock that don’t currently pay dividends start to pay one).

So this will mainly affect those who make high incomes, right?  No, because the price of stocks will drop, those who own stocks in 401k accounts, IRAs, individual accounts, and even Pension Plans (which are invested heavily in equities) will see the value of their holdings drop.  States with large pension plans and a lot of workers who are retiring soon may need to divert resources to shore up holes created in their pension plans.  Private businesses that have pension plans may need to cut costs to cover increased pension plan payments.

How much will share prices drop?  Predicting an exact amount is difficult since there are many factors that affect the stock market.  If a tax increase is enacted the same week that peace is declared in the Middle East and oil drops to $10 a barrel, stocks may well go up in price.  The effect of a return to 38% rates, experienced without any other events, however, would probably be to cause stocks to decline by 10-20%.  Note that everyone’s rate would not increase to 38%, and there are institutional investors who hold a lot of the shares.  This would mute the effect of the tax increase.

So, be wary of calls for higher dividend taxes.  The effects may well extend well beyond those who own stocks that pay dividends.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Picture Credits: Thomas Picard, downloaded from stock.xchng

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