As the Bush-era tax cuts are set to expire at the end of this year, there's a rather unsettling possibility that the current 15% tax rate on dividends could jump to 39.6%. Should that occur, it could prompt a sell-off in high-yielding stocks.
IN PICTURES: Top 10 Solutions For A Big Tax Bill
Partisan Gridlock Could Send Dividend Tax Rates Soaring
A result of tax changes enacted in 2003, tax rates on dividends and capital gains were cut to a flat 15% for all investors. Now, the Obama administration and congressional Democrats want to see both rates rise to 20% for married couples earning more than $250,000 per year. However, if partisan gridlock prevents these new rules from getting passed, pre-2001 bracket rates would come into effect by default boosting the tax rate on dividends to just shy of 40% for all investors regardless of their income levels. Given the current state of turmoil on The Hill these days, it's increasingly likely that such a scenario could come about.
High Yield Issues Could be at Risk
If that's the case, then investors may want to review their portfolios for any high-yield names that could be vulnerable to a price drop. While a complete listing would be fairly exhaustive, a number of large capitalization issues are worth mentioning, given their broad ownership and the fact that other issues may be afoot with these companies that could effect their ability to be remain as generous as they've been on the dividend front.
Big Tobacco now Tough Business Conditions
With current yields in excess of 6.7%, payout ratios around 75% and stable cash-cow business lines, shares of the big tobacco producers like Altria Group (NYSE:MO) and Reynolds American (NYSE:RAI) fit the classic definition of income shares. Given the controversial nature of their products, both companies continue to be assailed by health-related lawsuits that cut into cashflow while they struggle with a tough business conditions due in part to high U.S. unemployment.
AT&T Capex Expected To Rise
Bellweather U.S. telecom AT&T (NYSE:T), which currently offers a 6.5%, could be another vulnerable issue. The company is expected to up its capital spending on its network in response to the competitive challenge posed by the rapid adoption of Apple's (Nasdaq:AAPL) iPhone by rivals like Verizon (NYSE:VZ). Such an increase in capex would divert cash that would otherwise be allocated to dividends.
Duke Energy Could Leverage Up with a Major Acquisition
Another major dividend payer in the utilities space is Duke Energy (NYSE:DUK). Recently, the company's name made it on the list of possible buyers of the U.S. unit of German utility giant E.ON. If completed, it would be one of the largest utility deals this year, and would likely boost debt levels significantly for the buyer. Higher debt service charges would then cut into available cash for paying dividends.
The Bottom Line
While it's not an absolute certainty that dividend tax rates will soar next year, investors should at least make the effort to size up their potential vulnerability to such an outcome. (To learn more about the Bush-era tax cuts, check out The JGTRRA: Reducing Dividend Tax Rates.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
