No matter how the fiscal cliff negotiations work out, the odds are near 100% that dividends will return to being taxed at the ordinary rate. Subscribers are asking me how much less attractive this makes dividend stocks and how this change may affect my beloved dividend-capture strategy.
The short answers are: 1.) Yes, the stock prices are adjusting such that the after-tax yields are reflecting the tax impact, and 2.) Ironically, dividend capture becomes even more attractive in a more highly taxed world!
The key to understanding the latter argument is that dividend capture is a high-turnover strategy, where a shorter holding period is actually preferred. Good trades will rarely be held for 60 days, so most dividend income obtained by using this strategy is taxed at ordinary rates already. In order for dividend capture to be attractive after-tax, you must generate a sufficient return to overcome the tax drag. Consider this math:
- Example 1: Adhering to 60-day holding period means 1.5 dividends can be captured in one quarter. For an average yielding stock of 3%, this translates into a 4.5% return.
$100,000 x 4.5% = $4,500 x 0.85 = $3,825 after-tax income
- Example 2: Ignore the holding period and capture three 3% dividends per quarter, or a 9% return.
$100,000 x 9% = $9,000 x 0.65 = $5,850 after-tax income
With a successful capture strategy, after-tax income is more than 50% greater, despite paying higher taxes!
After Jan. 1, 2013, the after-tax income of the buy-and-hold dividend investor is going down. For the dividend-capture trader, your after-tax dividend income is going to stay the same, assuming equivalent trading results. The change in tax treatment actually makes dividend capture a more attractive option for generating after-tax income.
Alternatively, the new (i.e., old) tax regime reduces the level of dividend capture income you need to generate in order to stay competitive with buy-and-hold. In the example above, you could remain competitive with two trades per quarter instead of three.
So for you subscribers who are executing dividend capture now, do not worry. Our world is not really changing, and 2013 and beyond can continue to be good years for this strategy.