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How Will the Dividend Tax Increase Affect Covered Call Writers? By Guest Author Laurie Itkin

There has been a lot of hysteria and hyperbole surrounding the expiration of the Bush-era tax cuts and how it might affect dividend income. The Blue Collar Investor’s weekly list of covered call candidates often includes a number of dividend-paying stocks as shown in the green-highlighted column in the chart below:

 

Blue Collar Premium Watch List

Dividend yielding stocks

 

Should covered call writers shift away from dividend-paying stocks to non-dividend paying “growth” stocks (shares in a company whose earnings are expected to grow at an above-average rate relative to the market)?

Aside from the new 3.8 percent healthcare surtax on investment income (including capital gains and dividends), it is not certain that a drastic increase in the tax rate on dividends will occur. Since 2003, dividends (as well as long-term capital gains) have been taxed at a maximum federal rate of 15 percent. In 2003, 2008, and 2010 — a period which covers three different congresses and presidents of both parties — the current taxation of dividends at 15 percent has been maintained.

But let’s assume that the worst case occurs and the tax cuts are not extended. The Bush-era tax cuts are scheduled to “sunset” at the end of this month. If Congress doesn’t take action to extend the cuts or enact new rates, dividends will be taxed as ordinary income just as they were prior to 2003. If tax rates rise as scheduled, taxpayers in the top marginal income tax bracket would face a rise from 15 to 43.4 percent (factoring in the 3.8 percent healthcare tax) for dividends and a rise from 15 to 23.8 percent for long term capital gains.

This “worst case” isn’t relevant to most of us. First of all, most investors aren’t in the top tax bracket. Their tax rates might rise from 15 to 20-something percent, but the implication that everyone’s dividends will be taxed at 39.6 percent is inaccurate.

Second of all, many covered call writers trade in their individual retirement accounts (IRAs) so dividend tax policy does not affect the money that is compounding in the account.

I can tell you that this investor isn’t changing her strategy. I will continue writing covered calls on both dividend-paying and growth stocks based on fundamental, technical, and total return (dividend plus call premium) analysis. Yes, we can all moan about how Washington is sucking away our investment income but think about the alternatives; except for municipal bonds, interest paid on fixed-income securities (i.e. corporate bonds) is already taxed as ordinary income at the federal and state levels. There are a lot of high quality stocks that are yielding better rates through dividends than investment-grade corporate bonds and I will continue to invest in them throughout 2013.

Laurie Itkin, The Options Lady

http://www.theoptionslady.com/

 

Milwaukee seminar:

On January 19th, I will be one of 5 speakers invited to present at an all-day investment workshop for the American Association of Individual Investors. Here is the link for more information and the registration form:

http://www.aaii.com/localchapters/pdfs/20130119_milwaukee.pdf

Let me vent:

What happened this week in Congress (House) was nothing short of stunning. This site will remain apolitical but our representatives do impact our economy and as a result, our stock market. Dysfunctional represenatives are playing with our families well-being. There must be a NEGOTIATION that these players can agree to midway between both ends of the spectrum. That’s what our representatives are supposed to do…negotiate so that a reasonable solution can be achieved. This still may happen but it appears less likely now than it did previously. We are looking at possible tax increases for all, reduction in critical programs that the needy depend on, possible downgrading of US credit again and dare I say revisiting possibilities of recession. I do not think this will occur because I believe that the adults in the room will rise to the occasion and outshine the misfits. I must report, however, that many of our members have expressed to me that they will move more of their investment capital into cash until a solution is realized. Congress gets paid by us to govern. They are not doing their jobs. It is analagous to our stock brokers refusing to execute our trades but still expecting to collect their commissions. So I have a proposed solution: Tie all Congressional paychecks to a successful fiscal deal. No deal, no paycheck. Watch how fast this matter is resolved. Ultimately, our representatives must answer to us and that is a responsibility we must take seriously. (Deep breath)…thanks for hearing me out.

Market tone:

Despite my above rant I am still long-term bullish on our economy. Here are this week’s economic reports supporting this view:

  • Existing home sales rose by 5.9% in November, the best level in 3 years and up 14.5% from a year ago
  • Home inventory levels are down to 4.8 months of supply, the lowest level since September, 2005
  • New home construction fell by 3.0% in November but overall activity maintained its best pace since 2008
  • Housing permits increased by 3.6% in November, another positive for our economy
  • Third quarter GDP (A comprehensive scorecard of the country’s economic health. GDP represents the total value of the country’s production and consists of purchases of domestically produced goods and services by individuals, businesses, foreigners, and the government) expanded at an annual rate of 3.1% much better than the 1.3% rate from the 2nd quarter
  • Corporate profits were up 2.4% in the 3rd quarter, better than the 1.1% rise in the 2nd quarter
  • The Conference Board index of leading indicators fell by 0.2% in November, meeting analyst expectations
  • Durable goods orders were up 0.7% in November exceeding the 0.3% anticipated
  • Personal income was up 0.6% in November doubling the 0.3% expected
  • Initial jobless claims came in @ 343,00 for the week ending December 15th, lower than the 370,000 projected

For the week, the S&P 500 rose by 1% for a year-to-date return of 16%, including dividends.

Summary:

IBD: Market in a confirmed uptrend

BCI: Long-term extremely bullish but taking a cautious short-term policy of a higher-than-average cash position and selling only in-the-money strikes with low beta stocks and ETFs until our fiscal plan issues are resolved.

Wishing one and all a wonderful holiday season,

Alan and the BCI team (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

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About laurie

Laurie Itkin is Founder of The Options Lady where she mentors individuals to become successful self-directed investors in the stock and options market.

7 Responses to “How Will the Dividend Tax Increase Affect Covered Call Writers? By Guest Author Laurie Itkin”

  1. Barry B December 23, 2012 12:43 am #

    Premium Members,

    The Weekly Report for 12-21-12 has been uploaded to the Premium Member website and is available for download.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:

    http://www.youtube.com/user/BlueCollarInvestor

    Best,

    Barry and The BCI Team

  2. Bob Polin December 23, 2012 11:15 am #

    Alan, in response to your “Let Me Vent” section, I’ll vent too. The country knew this is probably going to happen, didn’t vote against every incumbent, so it deserves this Congress. If the country does one day throw every one of them out, and the new Congress is the same, then maybe we’ll try the next step – “Occupy Capitol Building” and block them from going to work, similar to what they did at TianAnMen Square. Human life is valued much more in this country, so our military won’t shoot us.

  3. Barry B December 23, 2012 4:26 pm #

    Premium Members:

    This week’s Weekly Stock Screen And Watch List has been revised and uploaded to The Blue Collar Investor premium member site and is available in the “Reports” section. There was an error related to the Weekly Rank in the downloaded data. This has been corrected. It is important to note that the change did not impact any stock selection decisions. Look for the report dated 12-21-12 RevC.

    Best,

    Barry and The BCI Team

  4. Gail December 24, 2012 7:18 am #

    Alan,

    You have a rule for 250 thousand shares of trading for stocks. Do you have a rule for option trading?

    Thanks and Merry Christmas.

    Gail

    • Alan Ellman December 24, 2012 11:29 am #

      Gail,

      Let’s call this a “guideline”

      I prefer options with a minimum of 100 contracts of open interest (OI) and/or a bid-ask spread of $0.30 or less.

      Happy holiday to all.

      Alan

  5. Marty December 24, 2012 3:46 pm #

    Alan,

    I’m with you 100% on your concerns about Congress and the cliff. I will also keep more cash on the side until I see what happens.

    Merry Christmas to you and the team.

    Marty

  6. Barry B December 27, 2012 2:02 pm #

    Premium Members,

    The Weekly ETF Report will be uploaded to the Premium Member site by the close of business today.

    Happy Holiday to all…

    The BCI Team

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