How Other Cliff Will Impact ETF Investors

The expiration of the Bush-era tax cuts on Dec. 31, 2012, would increase tax rates on most ranges of ordinary income including long-term capital gains along with qualified dividends.

But higher taxes won’t just affect wealthy taxpayers like some people think.

A recent report by the Tax Policy Center notes: “Every income group would see taxes rise by more than 3.5% of pretax income. Upper income taxpayers would experience the largest tax increases, both in absolute terms and as a percentage of income. The top quintile would see its tax burden rise by slightly over $14,000 per tax return, almost 6% of pre-tax income. Taxpayers in the top 1% of the distribution would experience an average tax increase of over $120,000, slightly over 7% of their pretax income.”

Dividends paid to stockholders will be hit hard. Instead of owing just 15% as they do today, investors who receive dividends will be taxed at according to their ordinary income tax rates.

Table 1 (below) shows the damage.

For example, individuals in the 25% bracket will get snagged for 31% versus 15% tax on dividends in 2013. Although certain tax brackets will completely disappear next year, what doesn’t go away are higher tax rates across the board on all remaining brackets. 

A Simple Case Study

What kind of impact will this have on dividend investors? Let’s look at the numbers.

Table 2 (below) illustrates an investor in the 35% tax bracket with $100,000 invested in a group of dividend stocks yielding 4%.

Our investor pays just $600 annually in taxes on those dividends in 2012, whereas they would pay $1,736 – or almost triple under new tax laws affecting dividends in 2013. Our illustration also includes the 3.8% surtax which begins next year on high-income investors.

The after-tax flogging is tremendous. Instead of yielding 3.4% after taxes, our investor reaps just 2.2%. 

Summary

The anti-income investment climate has officially arrived.

Right now, the Federal Reserve is slaughtering income investors with artificially low rates - and if that's not bad enough, taxes on dividend income will jump from 15% this year to a top rate of 39.6% next year.

This “dividend cliff” is a double whammy for income investors. For advisors, this represents a fine opportunity to help income-challenged clients with thoughtful solutions. Chasing high-yielding sectors is for amateurs; clearly, a more sophisticated approach is required.

One immediate strategy is to start stashing dividend-paying stocks and ETFs in tax-deferred accounts, especially for clients in upper income tax brackets. Asset allocation is still important, but smarter asset location will play an important role in helping investors to keep more of their money.