Dividends paid by electric companies make their stocks attractive, allowing the utilities to raise capital through stock instead of debt. If higher dividend taxes turned off investors, a utility's cost of operation would go up and could affect service to customers.
Updated: May 3, 2013 12:14PM
Are you ready for a 164 percent tax increase? It's just around the corner.
On Dec. 31, the maximum tax on dividend income will jump from 15 percent to 39.6 percent -- a 164 percent increase -- if Congress doesn't act to prevent it.
The low tax rate on dividends was set as part of the 2003 Jobs and Growth Tax Reconciliation Act. It set the maximum tax on dividends at a low 15 percent, and a zero tax rate on dividends for those in the 10 percent and 15 percent tax brackets -- mostly seniors who rely on dividend income. But that provision "sunsets" at the end of this year, along with the rest of the so-called "Bush tax cuts."
Many people will shrug their shoulders and say the tax on dividend income is paid only by wealthy people. Why should anyone worry if they pay a few more dollars in taxes on money they didn't "earn"?
But it's that kind of thinking that will likely prove disastrous in an economy struggling out of recession. So, here are a few points Congress should keep in mind before it allows taxes on dividend income to rise:
*It's not just the wealthy who collect dividends. According to a study by Ernst & Young, in 2007 there were 27.1 million tax returns reporting dividend income. And 36 percent of those returns reporting dividends received showed income of less than $50,000.
*It's not just older people who report dividend income. While nearly 60 percent of the returns showing income were filed by people age 65 and older, the balance of more than 40 percent came from younger people. For retirees, planned dividend income can keep them out of poverty and can keep them from tapping into federal benefits such as food stamps and Medicaid nursing homes.
*Over the last 60 years, dividends have accounted for 40 percent of the total return on stocks. So if you're a long-term investor in your 40l(k) or IRA, a big portion of your retirement security will come from dividends paid on the stocks you hold. Raising taxes on dividends will make those stocks less attractive to investors -- likely impacting your own retirement plan.
*A dividend tax increase could not only lead to "brownouts" in your investments, it could impact your actual electric utility service. Electric utilities paid out more than $17 billion in dividends in 2009 -- an average 70 percent payout rate. That makes their stocks attractive, so they can use stock instead of debt to raise needed capital to allow them to repair and expand the electrical grid. Where will you plug in your electric car if the industry can't raise capital to keep the nation's infrastructure updated?
The uncertainty hanging over the dividend tax is impacting the entire stock market. Chuck Carlson, author of The Little Book of Big Dividends (Wiley, 2010), for which I wrote the foreword, says:
"I view this [tax uncertainty] as a huge negative for stocks in general and dividend payers specifically should the current low tax rates not be extended. I think you will find a better buying opportunity for most stocks, including dividend payers, as the year progresses and uncertainties mount as to what will happen to tax rates in 2011."
In other words, don't expect the stock market to stage a huge rally with the threat of higher taxes hanging over it.
Even worse, any kind of tax increase during a shaky recovery is bound to have a negative impact on the economy. Yes, it's tempting to say that we need to reduce the deficit, but imposing a tax on capital is a very expensive and counterproductive way to do that.
Don't forget that dividend income is taxed twice -- once when the company earns the money to pay out, and again when it is received by shareholders. The impact of higher taxes on dividends hurts companies, shareholders and individual consumers.
As dividend-paying companies like utilities raise capital by selling stock, they expand their facilities, creating jobs and more revenues. When investors face falling returns because of dividend cuts, they are less likely to buy stocks. And when consumers face an income cut because of higher taxes on dividends, they slow their spending.
So, when you start hearing about this next tax increase, which will occur by simply letting the dividend tax rate increase as scheduled, don't shrug your shoulders and assume it will only impact the "wealthy." The impact will go far beyond those who actually pay the tax, as is always the case. And that's the Savage Truth.
Terry Savage is a registered investment adviser and a co-host of ''Monsters and Money in the Morning'' on WBBM-Channel 2 from 5 to 7 a.m. weekdays.