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:
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
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:
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.
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.
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 ([email protected])