Income Investing in a 2013 World

12/05/2012 10:45 am EST

Focus: MARKETS

There continues to be a lot of brinksmanship going on in DC these days, and it doesn't help the markets or investors when Washington plays politics with taxpayers' retirements...but there are a few simple things you can do, notes Martin Hutchinson of Money Morning.

If you listen to the press, Taxmageddon is going to be a "nightmare" for dividend stocks.

There's only one problem with this scary story: It isn't true.

Of course, I'll be the first one to tell you I'm not in favor of higher taxes on dividends. And it is true that if we fall off the "fiscal cliff," taxes on dividends will revert to the full income tax rate of each individual taxpayer. For the top taxpayers, that means the top rate on dividends could rise from 15% to 43.4%.

However, that's not as bad as it sounds, which is why I believe dividend stocks will remain the place to be in 2013. Here's why.

First, institutional holders of dividend stocks are taxed at their own rate, so they did not benefit from the 2003 cut in dividend taxes. That means they won't suffer from a new increase.

And even among individual investors, many have their investments in IRAs or 401(k)s or other tax-deferred accounts. These holders will continue to receive dividends that won't be immediately taxed.

As for those on more modest incomes, perhaps being retired and living mostly on their dividend income, they will pay taxes only at 15%, 25%, or 28%. These are the thresholds which have been indexed for inflation since 2001, meaning the vast majority of taxpayers will never get close to the 43.4% figure that makes for great scary headlines.

But it's not just all about tax rates. There are other reasons why savvy investors should continue to invest in dividend stocks in 2013. One of them is Barack Obama...

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2013 Dividend Stock Forecast
With President Obama now set to hold office for another four years, interest rates are likely to remain very low. In fact, Fed Chairman Ben Bernanke has said short-term rates will remain close to zero until the middle of 2015.

That's true even if Bernanke's current term of office ends in January 2014, since it's likely that if President Obama replaces Bernanke, his choice will be someone like Fed vice-chairman Janet Yellen, who is equally committed to a low-rate policy.

So while we could easily see a decline driven by sluggish earnings combined with investor suspicion of the companies' accounting policies to knock prices down, dividend payers would fall much less. That's because their yields would increase and their attraction compared to bonds would become even greater.

Of course, you would need to buy solid companies which maintain their dividends, but that's a lot easier than finding the next growth stock.

For investors, that leaves two kinds of companies to look at. One is the relatively few "dividend aristocrats," which have increased their dividends every year for the last 30, 40, or 50 years.

These provide almost completely reliable income, so any short-term price declines can be ignored. If they're in a non-financial business, they also have the advantage of providing inflation protection, as their earnings will tend to increase with prices, and their dividend increases should also keep pace.

Of course, these aristocrats tend to pay only moderate dividends, in the 2.5% to 4.5% range, but that's still better than you get on bonds today. And if you're living on the income, you are much better protected against a burst of inflation.

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MLPs and REITs Remain Attractive in 2013
The other type of attractive investment is a real estate investment trust (REIT) or energy-related Master Limited Partnership (MLP), which may offer a much higher yield that can also benefit from inflation, as the price of oil or real estate rises.

An attractive example is Linn Energy (LINE), which is an oil and gas MLP with an attractive current yield of 8%.

One of the reasons why I like MLPs and REITs is that these companies do not pay tax at the corporate level. It's one of the reasons why they generally pay a higher yield.

Because the truth is my real objection to paying individual tax on dividends is that most corporate dividends are paid out of income that has already been taxed at the corporate level, thus subjecting the income to onerous rates of double taxation (triple if you include state taxes) that may easily exceed 70%.

On the other hand—unlike MLPs and REITs—true operating corporations generally pay lower dividends, at a maximum of 5% to 6%, for two reasons:

  • First, dividend payout rates have generally declined, because dividends give no benefit to holders of stock options, and so are less beneficial to company management than share buybacks.
  • Second, the combination of low interest rates and rising stock markets in the last three or four years have made even traditional dividend-oriented stocks yield much less than they used to.

That' s why in my current Permanent Wealth Investor portfolio, more than half the current holdings are funds, MLPs, REITs, or other structures where the dividend is passed through to the investor, because regular dividend-paying companies with high yields and sound finances are hard to come by.

So yes, dividend stock investors need to brace themselves for higher taxes. But that doesn't mean they sell. Whatever the results of the "fiscal cliff" negotiations, dividend investors should continue pursuing these solid wealth-building strategies in 2013.

Don't let the taxes scare you—the road to true wealth still starts here.

Read more from Money Morning here...

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