How the Fiscal Cliff Deal Saved Dividend Stocks

dividend stocks Fiscal Cliff stock market
dividend stocks Fiscal Cliff stock market

The months-long wrangling in Washington over whether to extend expiring tax breaks went down to the wire, but eventually, lawmakers got the job done. In doing so, they also removed what could have become a huge threat to millions of investors who rely on dividend-paying stocks.

Increasingly in recent years, income-hungry investors have come to depend on dividend stocks as a key component in their overall investment strategies. With banks offering next to nothing for savings accounts and interest rates near historic lows on other income-producing alternatives like bonds, even conservative investors have had little choice but to embrace stocks for their lucrative dividend payouts.

Yet without a deal, that final refuge for income investors could have disappeared.

The 'What If' Scenario

Throughout the debate, most of the focus was on the prospective increases in the overall tax rates that would have taken effect in 2013, with particular attention to the changes affecting high-income taxpayers. With rate increases that would have boosted taxes by three to five percentage points, the impact on the economy and on individual budgets would have been significant.

But the biggest potential tax hike in the fiscal cliff would have been applied to dividend stocks. Since the early 2000s, dividend taxes have been capped at 15 percent. That top rate would have increased to 39.6 percent, and the additional 3.8 percent Medicare surcharge tax would have resulted in taxes on dividends nearly tripling for high-income earners -- and nearly doubling for a wide swath of ordinary investors.

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In particular, one intricacy of the tax laws could have led companies to make a big change in their dividend policies. For years, the tax rate on dividends has been the same as what investors pay on long-term capital gains. That equal treatment gives no tax incentive one way or the other for companies to decide whether to return extra capital to shareholders through dividends or by other means, such as share buybacks.

But without a fiscal cliff resolution, capital gains rates would have stayed relatively low at 20 percent -- just half the rate that would have prevailed for dividends.

Such a wide disparity could well have led companies to replace dividends with stock repurchases. That in turn would have put dividend investors in a bind, as the steady gains in dividends over the past several years could have reversed themselves in one fell swoop and eliminated a key source of investor income.

Even Now Not All Dividends Are Created Equal

In the end, the deal set both capital gains and dividend rates at 20 percent for taxpayers with incomes above $400,000 for singles and $450,000 for joint filers. That kept the old law's equal treatment of dividends and capital gains in effect and should therefore prevent companies from having to pull back on dividends just to maximize their tax efficiency.

Even though the new tax laws have taken effect, you still need to understand that those low dividend tax rates don't always apply. The 15 percent and 20 percent maximum rates only apply to qualified dividends, which exclude payouts from certain companies.

For instance, many of the most popular real estate investment trusts, particularly those like Annaly Capital (NLY) and American Capital Agency (AGNC) that focus on mortgage-backed securities, are subject to tax at your higher ordinary income rate. For more information on whether your stocks pay qualified dividends, contact your company's investor relations department.

In addition, if you're a frequent stock trader rather than someone who buys and holds stocks, you could lose the favorable dividend tax rate. To get the lower rate, you have to own a stock for more than 60 days during the roughly four-month time frame surrounding the dividend payout.

Don't Count Out Dividends

Despite the worries of December, dividend stocks have emerged from the fiscal cliff debate stronger than ever. Given how hard it is to get income anywhere else, having dividend stocks in your portfolio is likely to remain an essential part of making ends meet for those who live off their investments.

If you're interested in some of these dividends on your quest for high-yielding stocks, The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks."

Motley Fool contributor Dan Caplinger has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital.