Temporary Relief from Political Inertia
Late last month after an exacerbating delay, the lame duck Congress finally passed legislation that extended the expiring Bush tax cuts for two more years.Perhaps the biggest relief may have been in estate taxes where limits for both the exemption and lifetime gift exclusion were raised to $5 million.
From an income tax perspective, this eleventh hour compromise represents a victory for the Republicans in their push for the extension of the 15% tax rate on dividends and long term capital gains.This two year extension may have a dramatic impact for several investment asset classes.
It is my view that dividend paying stocks may derive the greatest benefit from the continuation of these low tax rates.Current dividend yields compare favorably to yields on many fixed income investments as interest rates have remained at historical lows.Due to the fear of rising interest rates, investors have recently reversed a trend by selling rather than purchasing bonds.Enhanced by these low tax rates, dividend yields on many stocks have become attractive to investors seeking a bond alternative.
Despite the appeal of these dividend yields, many investors are concerned that the slow GDP growth in the US will impair the ability of blue chip companies to increase earnings and distribute higher dividends.However, many multi-national companies are significantly growing their overseas revenues by targeting their products to the emerging middle class in developing markets.If the analysts are correct and the GDP growth rates in these markets significantly out-pace the United States, earnings growth for these US domiciled companies should benefit accordingly.
Adding fuel to this dividend fire, some of the major financial service companies, who accepted funds from the federal government during the financial crisis, have either fully re-paid these funds or intend to do so in the very near future.Freed from the shackles of oversight, they are seeking approval from the government to remove restrictions for the payment of dividends.If the government acquiesces, many analysts believe that demand from income starved investors will ignite fund flows into the financials and could lead to subsequent gains in these stocks.
Meanwhile, tax exempt bonds have been whipsawed recently by some analysts' reports that defaults in coming years might explode into hundreds of billions and by anend of the year rush to market by municipalities to issue taxable Build America Bonds(BABs) before the federal subsidy on bond interest expired.The extension of the Bush tax cuts also placed a damper on demand as the expected increase in the so-called tax equivalent yield that would have resulted from rising tax rates failed to materialize.The boost in yields resulting from the recent sharp decline in prices on tax exempt bonds may represent an investment opportunity for savvy investors. For example, some pension plans are currently deploying funds in tax exempts despite being unable to reap any benefit from tax free interest.
The positive effect to the economy of the reduction in the employee's portion of the FICA tax from 6.2% to 4.2% is problematic.Essentially, the government is promoting consumption by the workforce with this 2% savings.In my opinion, the economy would have been better served by providing this reduction to employers instead.For a small business looking to hire additional employees, a 2% reduction in payroll taxes may have represented the financial elixir to fund this undertaking.Unemployment is one of the headwinds preventing the economy from escaping this pattern of anemic growth and this subsidy to employers could have represented a much needed antidote.
For planning purposes, the rush to convert IRAs to Roth IRAs is over.While the ability to spread the income over two years is gone, a taxpayer can achieve a similar result by converting half of the IRA in 2011 and the other half in 2012 while tax brackets remain unchanged.And finally the untenable status of a $1 million federal estate tax exemption has been replaced by more rational $5 million figure.For individuals and estate planners who had been in a quandary due to the uncertainty, this change represents welcome relief.
Clifford L. Caplan, CFP®, AIF®
This material has been provided for general informational purposes only and does not constitute either tax or legal advice.Investors should consult a tax or legal professional regarding their individual situation. The purchase of bonds is subject to availability and market conditions.There is an inverse relationship between the price of bonds and the yield:when price goes up, yield goes down, and vice versa.Market risk is a consideration if sold or redeemed prior to maturity.Some bonds have call features that may affect income.
In the News:I was quoted in two Associated Press articles in December.On December 8th, in an article titled “Tax Deal Offers Enticement at all Income Levels”, I offered my opinion about the impact of the tax law on dividend paying stocks.And on December 16th, in an article titled “Market's Choppiness Simplifies Fund Checkup”, I suggested that a mutual fund should not be considered for redemption after one poor year.