Why Tax Rates Matter To Dividend Investors
by | Posted 11.13.2012 | Post Comment (1 Comment)

There has been a lot of discussion in the past few months regarding tax rates for dividend investors. I guess one big reason is that in the US, higher tax rates were a big part of the most recent election. While the democrats led by Barack Obama campaigned on higher taxes overall, republicans said rates needed to remain low. There are a million reasons to keep taxes low, the main ones being:

-lower taxes give incentives to reinvest
-the biggest problem is government spending, not revenues
-for dividends specifically, those amounts have already been taxed at the corporate level

The problem though is that rates WILL go up. It’s only a matter of how and when. Why? Governments all around the world are feeling the heat as deficits pile in and their economies continue to struggle. It’s not just happening in the US but everywhere else.

Retirement Non-Taxable Accounts, A Perfect Shield?

I’ve heard from a few investors that said they didn’t care much about higher tax rates on dividends. Why? Because they hold their dividend portfolios in retirement accounts where income is not taxable. That is certainly a great idea when possible as it will end up making a huge long term difference. Why? Let’s say you are making $1000 per year in dividends. In a taxable account, you’d pay $400 of taxes. In a shielded account though, you could reinvest that money for a very long term without paying taxes.

It’s Far From Perfect Though

You see, when a company like Microsoft has a surplus of cash. It can either:

-reinvest that money
-pay it out to shareholders

Payments to shareholders are usually made either as dividend payments or stock buybacks. If a significant number of shareholders are paying higher taxes on those dividends, they very well might prefer that Microsoft buy back shares with the money instead (which indirectly creates higher stock prices). Why? Because taxes on those will be capital gains which can be postponed by longer term investors.

So yes, RRSP’s, IRA’s and other such accounts protect investors from higher dividend taxes but if the companies still prefer to shift some of their cash to other means, then even those of us with “shielded accounts” will end up being hurt. It’s unfortunate but there’s no easy way to come out a winner here.