Get Ready for Dividend Tax Shock

07/26/2010 11:48 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

Are you ready for a 164% tax increase? It’s just around the corner. 

On December 31, 2010, the maximum tax on dividend income will jump from 15% to 39.6%—a 164% increase—if Congress doesn’t act to prevent this huge tax on capital. 

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%, and a zero tax rate on dividends for those in the 10% and 15% 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,” so dividends will be taxed at the same rate income will be—as much as 39.6% for top earners.

Many people will shrug their shoulders and say that the tax on dividend income is only paid by wealthy people. Why should anyone worry if they pay a few more dollars in taxes on money they didn’t “earn”? Most 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.

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% of those returns showed income of less than $50,000.
  • It’s not just older people who report dividend income. While nearly 60% of the returns showing income were filed by people age 65 and older, the balance of more than 40% 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 past 60 years, dividends have accounted for 40% 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—perhaps impacting your own retirement plan.
  • And a dividend tax increase could not only lead to “brown outs” in your investments—it could impact things like your electric utility service. Electric utilities paid out more than $17 billion in dividends in 2009—an average 70% 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, claims the Edison Institute, which represents utilities. Where will you plug in your electric car, if the industry can’t raise capital to keep the nation’s infrastructure updated?

Even worse—any kind of tax increase during a shaky economic recovery is bound to have a negative impact on the entire 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 counter-productive way to do that. 

As dividend-paying companies like utilities expand their facilities, they create jobs and more revenues. When consumers face an income cut because of higher taxes on dividends, they slow their spending. And when investors face falling returns because of dividend cuts, they are less likely to buy stocks. 

So, when you start hearing about this stealth grab at the nation’s wealth by simply letting the dividend tax rate increase as scheduled, don’t just 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. 

What do you think? Please join the conversation and have your say.

Related Articles on MARKETS