The Fiscal Cliff That Wasn't

What if there was a fiscal cliff and no one fell off of it?

With stocks at their highest level in four years, some pundits, bears and politicians claim that stocks will certainly plunge if the Bush-era tax cuts are allowed to expire on January 1, 2013.

The current tax rate on dividend payments and capital gains is 15 percent. Should the tax cuts expire, dividends and capital gains could be taxed at ordinary income rates. That could be particularly troublesome for retirees who receive a sizeable amount of income from dividends. Those individuals could go from paying 15 percent to over 40 percent depending on their tax bracket.

That's what is causing some pundits to call for the end of the dividend stock bull market.

In the current low-interest-rate environment, dividend stocks have been white hot. Everyone is searching for yield, so much so that anything with even a little extra return is trading at a premium.

Nearly all preferred stocks are trading above par. Closed-end funds that generate solid yields are trading at premiums to their net asset values. And because stock prices have moved so high, it's getting harder and harder to find a quality dividend-paying stock with a yield over 4 percent.

So it's logical to assume that if an investor's taxes are going to go up by 100 percent (or more), he's going to dump the investment in favor of something more tax efficient, or investments that don't have the same amount of risk. After all, if the net (after taxes) reward is suddenly smaller, it doesn't make sense to take the same amount of risk.

Only it does.

First of all, where else is an investor going to find yield? Certainly not in treasuries. A 10-year treasury yields about 1.75 percent. The top three-year CD in the country pays 1.42 percent. A ten year municipal bond rated AA pays under 2 percent and a 10-year A rated corporate bond pays 2.8 percent.

The thing to remember about bonds is the coupon remains the same for the life of the bond. So let's say you buy $10,000 worth of an A rated corporate paying 2.8 percent. Every six months, you'll receive a payment of $140 or $280 per year.

That means this year, you'll receive $280. Next year, you'll receive $280. In five years, you'll be paid $280. And you know what you'll get in 2022? You are correct, $280.

Today, $280 on a $10,000 investment isn't horrible. In ten years it will be pathetic, even if inflation stays low. In 2012, the average inflation rate has been 2.21 percent, well below the 3.4 percent historical average.

But let's assume the next ten years are difficult and inflation stays at the same extremely low levels as today. In ten years, you'll need $12,443 to buy the same $10,000 worth of goods today.

And your 2.80 percent bond (before taxes) isn't going to cut it. You will almost definitely lose buying power over the next decade. And that's if inflation stays at these extremely low levels.

With the Fed's recent announcement of seemingly indefinite quantitative easing, most people believe inflation is going to take off.

If inflation reverts back just to the historical average of 3.4 percent, you'll need $13,970 in 2022 to buy $10,000 worth of today's goods.

The only way to keep pace with and stay ahead of inflation is with Perpetual Dividend Raisers. These are stocks that raise their dividend every year.

But, "Wait," you say. "With the fiscal cliff coming, dividend stocks are going to fall." Not so fast. It certainly seems like they should. Only, in the past they haven't.

I took a look at 104 Perpetual Dividend Raisers to see how they performed from 1985-2002, when dividends were fully taxable, and from 2003-2012, when taxes on dividends were just 15 percent. The results are surprising.

In the first, fully taxable period the average price appreciation of these stocks was 13.7 percent. In the second, the average gain for these stocks was 8.1 percent.

The discrepancy gets even larger when dividends are considered. But it's not just this special class of dividend payers that outperformed. The S&P 500 also posted more than double the average annual price appreciation during the high-tax years versus the low tax ones.

There may be other valid reasons to believe that a sell-off is coming if taxes on dividends and capital gains increase, but market history does not back up that theory.

Many believe that even this dysfunctional Congress will figure out a way to keep taxes low for at least another year, which could help dividend stocks stay lofty.

But even if they are unable to arrive at an agreement, don't rush out and sell your Perpetual Dividend Raisers just because taxes are going higher. In the long run, history tells us you'll be sorry you did.

Marc Lichtenfeld is the author of Get Rich with Dividends, A Proven System for Earning Double Digit Returns, the Associate Investment Director of the Oxford Club and the Editor of the Ultimate Income Letter.

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