Dividend cliff-jumping

At some point, the 15% tax rate on dividends will go up.  Or will it?  We don’t know for sure. But there are all sorts of dire predictions about the future of dividend yields and stock prices based on the higher dividend tax rate that will apply if we are swept off the fiscal cliff. Some are even suggesting selling dividend-rich stocks before year-end.  Is this good advice?  Let’s look at the facts.

What exactly is the link between dividend tax rates, stock prices, and yields?  If you weren’t paying attention on the day they taught tax history, below is a chart showing the marginal tax rate on dividends for the last fifty years.  As we can see, the rate has gone from 90 percent (!) in 1961 to 15 percent today, with ups and downs along the way. Capital gains rates have generally declined as well.

US tax rates on dividends and capital gains, 1961-2011

Next up, prices and yields

Now let’s look at historical US stock prices (below), as represented by the S&P 500. We see a steadily rising line, with dips and surges along the way (red line, left scale).

The dividend yield (green line, right scale) looks small, and it is. Its trend is generally downward since the 70’s, ranging from a high of 5.68% in January 1982, to a low of 1.16% in January 2000.  Currently, the S&P dividend yield is around 2%.

The tax rate (blue line, right scale) shows the sawtooth yet declining Federal tax rate over the last 41 years.

S&P 500 price, S&P 500 yield and dividend tax rate, 1971-present. Data source: Bloomberg.

Cause or coincidence?

So the long term trends show falling tax rates, rising stock prices, and a decline in dividend yields. Is there a causal relationship here? Did lower tax rates cause the S&P to rise? I don’t think so. Did they cause companies to reduce their yields? I doubt it.

Companies have three choices with free cash flow: pay dividends, buy back stock, or make acquisitions. They base cash use decisions on many factors; I expect individual tax rates are pretty low on that list.

Moreover, a large portion of the dividend stream is not taxed until years later; most gains and dividends in tax-preferred accounts like IRAs, 401(k)s and pension funds defer taxes until withdrawal. Endowments are not taxed at all.

Cliff plunging or not, you can always steer more of your dividend-paying holdings into your own tax-deferred IRA or 401k and not worry about the tax-consequences for many years. For most investors, the overall impact of higher taxes on dividends will be minimal, I believe.

What matters

Far more important than trying to strategize on unknown future tax rates is simply to own a diversified portfolio that matches your investment goals and risk tolerance. For most investors, that portfolio would include dividend paying stocks. I suggest owning stocks through index ETFs, keeping expenses and tax burden low. See our Dividends on Dividends article to see just how important dividend reinvestment has been in the 5300 percent gain in the Dow index over the last 40 years.