BOSTON -- What if one of your key sources of income were taxed at three times the rate you pay now?
That's a realistic possibility next year for high-income investors who own dividend-paying stocks or mutual funds. Dividend investors earning modest income and retirees who count on quarterly payouts could face a higher rate as well.
Investors have enjoyed historically low rates on investment income since 2003. But those will expire in January unless Congress and President Barack Obama reach a compromise first on taxes and government spending.
Failure to reach a deal would trigger higher rates on other income as well, plus automatic federal spending cuts. The combination could send the economy back into recession.
The prospect of higher rates on dividend payouts starting in January has left dividend investors, as well as dividend-paying companies, with plenty of news to track and what-ifs to consider.
Here's a look at the key moving parts:
Investors today pay 15 percent tax on most dividends and on capital gains, the profits from selling investments that have appreciated in value.
Unless Congress and Obama say otherwise, dividends will be taxed as ordinary income in 2013, the same as wages. So rates will go up depending on which income bracket a taxpayer is in.
For the highest earners, the dividend rate could jump to 43.4 percent. The president wants to restore a 39.6 percent ordinary income rate for top earners, up from the current 35. High-income taxpayers will also face a 3.8 percent tax on investment income to help pay for Obama's health care overhaul.
For those in middle tax brackets, dividend rates in the 20 to 30 percent range are likely.
The result is that middle-income earners could pay a dime or so more on each dollar of dividend income flowing into a taxable account. For high earners, it would be a quarter or so more.
Dividend rate increases could be smaller if congressional leaders and Obama agree on a compromise to raise the level to something less than what the president wants.
A tax bill can be delayed by holding investments in a tax-sheltered account. But many investors, especially those in higher tax brackets, don't rely exclusively on an individual retirement account or 401(k), in which earnings can grow tax-free.
Dividend-paying companies want investors to be taxed minimally because it makes their stocks more attractive to hold. And many companies are reviewing their dividend policies, now that it appears investors could soon pay higher taxes.
Those companies face a decision: Keep dividend payouts at current levels and see how the budget talks go, or distribute special payouts in December, before taxes go up.
A few companies already are approving such unusual "fifth quarter" dividends, the term that Howard Silverblatt of S&P Dow Jones Indices uses for these payouts.
"If I'm in the top tax bracket, a company better have a great reason for paying me after Jan. 1 when my rate will be 43 percent, rather than the 15 percent I could have paid back in December," Silverblatt says.
In late October, telecommunications company IDT Corp. said it would make a special payment this week, then suspend its quarterly dividend. "Our stockholders are best served by paying this dividend now," IDT CEO Howard Jonas said.
Manufacturer Leggett & Platt and industrial products maker Johnson Controls have announced plans to move their next payouts to December to beat a potential rate increase. In both instances, the payouts will be made less than a week before year-end.
Dividend-paying companies have another week or two to decide whether to make special payouts, Silverblatt says. Waiting much longer would complicate matters because dividends are typically distributed a few weeks after the payout is announced.
"Companies still have a little leeway to see how the negotiations start," Silverblatt says. "But you don't want to wait until Dec. 25 to do something, because that would be too late."
In the long term, higher dividend tax rates should lead companies to consider whether to buy back some of their stock rather than approve further dividend increases.
It could be a better use of a company's cash holdings. By repurchasing stock, companies reward investors by increasing the value of remaining shares. Per-share earnings get a lift as results are divided among fewer shares.
Other companies could continue increasing dividends, but at a more modest pace than when the payouts were taxed at a lower rate.
"If you've increased a dividend five years in a row, you're probably going to continue to do so, if you can," Silverblatt says. "But rather than increasing it 10 percent, it may be just 8 or 6 percent."
Higher rates would make dividend stocks less attractive because investors would keep less of their earnings. But dividends would still offer attractive after-tax yields relative to many investment alternatives.
For example, 10-year Treasurys yield about 1.6 percent. That's substantially below the average 2.64 percent yield of the 404 dividend-paying companies in the S&P 500 stock index.
That's upside-down from the normal relationship between those investments. Since 1962, yields of S&P 500 stocks have averaged 43 percent of Treasury yields, Silverblatt says.
And Treasurys don't offer the growth potential that stocks do from price appreciation. Even considering higher rates, dividends offer higher after-tax returns than Treasurys, albeit with greater risk. Dividends' after-tax yield advantage is even wider compared with interest earned from bank accounts.
"Even with a higher tax rate," Silverblatt says, "there's plenty to like about dividends."Copyright © 2014 Paddock Publications, Inc. All rights reserved.