Why Dividend Stocks Aren't Doomed After All

Millions of investors have made big bets on dividend stocks lately, turning to their higher-yield income streams as an alternative to thoroughly inadequate payouts from other income investments. By doing so, they've been willing to take on the risk of investing in stocks versus less volatile instruments, some of which guarantee principal repayment.

But an even bigger risk looms large at the end of this year: the expiration of the low tax rates on dividends. If those provisions expire -- and it's increasingly looking like a dysfunctional government will allow them to -- could it spell the end of the three-year bull market?

The end of an era -- maybe
For more than a decade, taxpayers have enjoyed lower tax rates on their income. But the tax cuts of the early 2000s came with a Cinderella-like deadline, and in this case, the midnight clock-chimes are set to come on Dec. 31, 2012.

At that point, several things will happen. Higher income tax brackets will apply to all kinds of income and at all levels, as the special 10% bracket will disappear and the top tax rate will rise to 39.6% from its current 35%. Capital gains taxes will jump from 15% to 20%, and the estate tax will apply to many more families as the wealth threshold falls back to around $1 million.

But one of the biggest hits will come for dividend investors. Come 2013, dividends will get taxed at full ordinary rates -- meaning that some high-income taxpayers will see their taxes jump from 15% to nearly 40%.

Much ado about nothing?
A couple of years ago, when this issue first came up, I noted that despite concerns that a tax increase could hit the stock market hard, there were many reasons to think it wouldn't. That time, the government kicked the can down the road with a two-year extension of the tax cuts. It's entirely possible that the same thing will happen this time around.

But there's an even better reason to stay confident about stocks this time around. In the past, when tax rates have risen, the stock market hasn't been affected. In fact, research from a SunTrust strategist discovered that returns were actually better in tax-hike years than in tax-cut years.

Focusing on dividend stocks
Moreover, when you drill down on dividend stocks, you have to consider several factors:

  • Many popular dividend stocks already don't get a favorable tax rate. Mortgage REITs Annaly Capital (NYS: NLY) and Chimera Investment (NYS: CIM) have their dividends taxed at full ordinary rates because of the source of the income they generate, so a small increase in overall marginal rates won't have a big impact on them.

  • Many investors already shelter dividend stocks within tax-favored accounts like IRAs. Since they're not worried about taxes, they aren't likely to change their strategies.

  • Perhaps most important, many of the most reliable dividend stocks are in industries that have historically held up well even in overall stock-market downturns. Procter & Gamble (NYS: PG) , Johnson & Johnson (NYS: JNJ) , and Coca-Cola (NYS: KO) all have around half a century of annual dividend increases under their belts. While products like Tide detergent, Band-Aids, and cola drinks aren't entirely recession-proof, these companies aren't the sort of high-growth up-and-comers that tend to crash and burn in big stock-market declines.

When you put all these things together, it's easy to conclude that if anything, dividend stocks are more insulated from a potential tax-rate hike than many of their less income-friendly counterparts.

Don't panic
So if you're afraid that Washington gridlock will jeopardize your portfolio, you can stop worrying, at least on this score. And whether an aging bull market eventually ends in the face of higher taxes or not, select high-quality dividend stocks will still be a good way for investors to ride out the storm.

Which dividend stocks are the best, then? Let me invite you to read more about dividend stocks in the Motley Fool special report "Secure Your Future With 9 Rock-Solid Dividend Stocks." A free copy can be yours today, in which you'll discover everything you need to know about these nine generous dividend payers.

At the time thisarticle was published Fool contributor Dan Caplinger has never been big into gloom and doom. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Johnson & Johnson, Annaly Capital, and Coca-Cola. Motley Fool newsletter services have recommended buying shares of Annaly Capital, Johnson & Johnson, Coca-Cola, and Procter & Gamble, as well as creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always pays you dividends.

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