The Fiscal Cliff…Opportunity Or Doomsday?

Notice The Rainbow?

I wasn’t sure I was going to even write about the upcoming potential “fiscal cliff” on this blog. Frankly, I’m not following any of  the latest news out of Washington, as I don’t really care about politics or anything else that comes out our dysfunctional and argumentative headquarters USA. I always focus on the long-term. Changes in taxes and government spending levels have been almost as common as changes in Presidency. I’m investing in long-term opportunities, and my favorite holding period is forever. 4-year or 8-year changes in government taxation and spending levels are just blips on my radar. They can be pretty large blips, don’t get me wrong…but they’re still blips.

What I’m going to do is to give my quick take on things, and provide you some excellent links on this matter. 

First, what is the fiscal cliff? It’s basically a term used to refer to the potential automatic spending cuts and tax increases that could occur if leaders in Washington do not come to terms on an economic plan going forward. This “cliff” would start at the beginning of 2013, and could be quite sharp based on the sheer amount of spending reductions and revenue changes, as well as the abruptness of it. It’s designed to quickly reduce the United States budget deficit. It is the jarring and rather messy nature of it that has some economists worried. There is no doubt that spending cuts are necessary as well as an increase in the revenue that the U.S. government takes in (due to our ever-expanding deficit), but the speed and nature of the cliff brings concerns of a potential recession with it.

For a rather robust explanation of the fiscal cliff, please visit the Wikipedia article: Fiscal Cliff

I think the important thing that us dividend growth investors have been focusing on is the potential dramatic rise in dividend income taxation. The tax rate on dividend income, with the cliff, would automatically raise from 5-15% (depending on your ordinary income tax rate) on qualified dividends to a taxation level at your full ordinary income rate, with the cap coming in at 39.6%. I don’t particularly concern myself with this. First, I’m not at an income level to where this will have a large impact on my overall bottom line. Second, dividends have been historically taxed at higher levels. People tend to focus too often on the recent past and try to project this out into the far future. We’ve been very fortunate with very low dividend tax rates over the last decade. If dividends are allowed to be taxed at marginal income, that will be more along the lines of what dividend investors were faced with for decades before George W. Bush passed what’s now known as the Bush Tax Cuts, including the dividend/capital gains tax cuts.

Another thing to keep in mind is that companies that have long histories of paying and raising dividends will not be likely to all of the sudden change policy if dividends are all of the sudden taxed at levels that are truer to historical averages. Coca-Cola (KO) has been increasing dividends for the past 50 years. This is a company culture of rewarding shareholders that doesn’t just turn off overnight. Coca-Cola has been paying out dividends when they were being taxed at 50% and higher rates. I don’t anticipate them cutting off a spigot of dividends that have been flowing for over 100 years because dividend taxation doubles from a very low relative rate.

Also, as a dividend growth investor I seek to maximize my potential passive income. I also look to have a satisfactory total return, including capital gains (realized or unrealized). I do not, however, seek to avoid taxes. Seeking an investment strategy to avoid taxes would probably involve stuffing cash under your mattress. This is not intelligent investing. I, of course, would love to minimize my tax bill. But the choice between maximum investment gains and minimum taxes is obvious, especially when the latter choice usually comes with earning less money overall.

Would you ever say to yourself: “I wish I wouldn’t have gotten a $10,000 raise at work. Now I have to pay more taxes!” Probably not.

Overall, I feel that spending cuts and tax increases are necessary. The continued rapid expansion of our national debt cannot continue forever. The deficit must be addressed. Whether this happens through negotiations (unlikely), or a self-imposed “fiscal cliff” (more likely) is really of minimal impact to long-term investors. It will be painful at first, but the contraction of our deficit is good for the long-term economy. The key is to focus on investing in high quality companies that have a rich history of rewarding shareholders and do relatively well in any economic cycle. Companies like Philip Morris International (PM), PepsiCo Inc. (PEP) and Johnson & Johnson (JNJ) come to mind. People are still going to smoke, eat/drink and take medicine if taxes are higher. One only needs to look at how some of these companies performed in the recent Great Recession to have a good idea of how they’d perform in a tough economy post-cliff.

Now, as promised I’m going to share some fantastic articles from fellow bloggers on the fiscal cliff and how they may impact your investments.

The Fiscal Cliff and its Impact to your Portfolio

Dividend Growth Investing and the Fiscal Cliff

Why I am not worried about the Fiscal Cliff and Dividend Tax Increases

How I learned to stop worrying about the Fiscal Cliff and you can too.

How about you? What’s your thoughts on the fiscal cliff?

Full Disclosure: Long KO, PM, PEP, JNJ

Thanks for reading.

Photo Credit: FreeDigitalPhotos.net

Comments

  1. Larry says

    You can always count on the American government to keep kicking the can down the road to avoid paying this massive debt. As we keep printing money to finance our debt inflation will continue to rise. Inflation is the one reason the stock market will always go up in the long term. At least we have that to look forward to.

    • says

      Larry,

      You make a great point. As inflation decreases the nominal value of money, the price of goods in turn go up. As the prices of those goods go up, the revenue of the companies that manufacture said goods goes up. As the revenue goes up, the stock prices likely go up.

      I agree. The stock market is an excellent inflation hedge if used correctly.

      Best wishes!

  2. says

    Thanks for the mention. I really liked your example about the 10,000 salary raise. Investors should be investing in the best opportunities out there, not to minimize taxes is another point i really like.

    I was hoping for a 10%-15% declines, but for whatever reason these are not happening yet..

    • says

      DGI,

      No problem on the mention. I’m just glad you continue to do what you do. I know first-hand how hard it is!

      I’m with you. I’m actually quite surprised the market has been rallying as much as it has. I anticipated a fairly sizable drop, and with a deal on the cliff a strong rally…or if the cliff happened a further drop in the market. But, I’ve been clearly wrong. Just goes to show you that trying to time the market and anticipate market moves is really impossible and rather pointless.

      Best regards!

  3. says

    I’m with ya – tax changes won’t make companies stop paying dividends. A great company is a great company regardless of who’s in charge.

    And when you retire your tax rate will be the same or lower than today, so it really won’t make much difference to you anyhow.

    • says

      Headed Home,

      You make a great point on the retirement income tax rate there. That’s something I probably should have mentioned in the article.

      That’s one of the great things about being financially independent, specifically on a low income amount due to living frugally – you pay significantly less taxes than everyone else. No payroll tax, and due to a low income you’ll also have less Federal taxes. I also live in Florida, so no state income taxes.

      Best wishes!

  4. Chris says

    Thanks DM for your thoughts on this. I like your salient point regarding your planned investment period, it adds a lot of perspective to the issue. I continue to add to my portfolio based around the long term rather than the expected earnings for the next fiscal quarter. I should be able to break $1,000 in dividend income next year so long as things stay on track for me.

    Thanks for your continuing efforts with this blog. I always appreciate reading it.

    • says

      Chris,

      I’m glad you enjoyed the article. Thanks for stopping by and taking time to read it. Means a lot!

      I’m glad you take a long view on things. Companies will be worth much more 20 years from now than they are now as they continue to sell more products to more people. It’s just simple math. The key is holding a major portion of your net worth in investments that are secular and shine in almost all economic cycles. I don’t care if we have flying cars in 50 years, people are still going to eat and need medicine.

      Best wishes!

  5. says

    DM,

    I’m in the same boat as you. While I would prefer for the taxes to stay at the current rates, it’s not something that will make me change my investment philosophy. I’m still hoping for a big decline to put a bunch of capital to work. It’s times like these that are tough. Do you go on and put capital to work even though there’s not any really deep values or do you hold off and wait for a chance to get in lower even though that might not ever come? That will definitely be something that I’ll struggle with at least at the beginning once the economy does start to pick up and the markets as well.

    • says

      Pursuit,

      Absolutely. Who wouldn’t enjoy paying less taxes? I certainly don’t want to write out checks to the government, especially if I feel the money is being spent irresponsibly (as it is now). But, if the tax base is broadened and rates are reasonable..and spending is reigned in appropriately we’ll all be better off in the long run. I do hope that our government does the right thing. We shall see. I’m not keeping my fingers crossed.

      You have a great question there as far as putting capital to work rather than holding some “dry powder” in the tank for deeper values. I think I’m going to write an article about this.

      Some of this depends on your timeline. I really believe that if you’re interested in reaching financial independence in 10 years or so you’ll be best off investing as often as possible and keeping your allocation levels proper. A longer timeline of investing (say 30 or more years) would allow one to be a little less active with capital and make decisions less often.

      I don’t advocate buying no matter what. I simply advocate allowing capital to start working for you as much and as often as possible, as valuations in qualitatively attractive equities allow. I also always keep in mind that I’ll be happy I purchased MCD at $88 or at $90 when it’s trading for levels 3-5 times higher 20 years from now. The $2 per share seems like a big difference now (and it is at over 2%), but that difference is mostly lost over a long period of time. The people that bought Apple at $100 per share paid twice as much as the people that purchased it at $100 per share…but they’re both doing well. I try to focus on the big picture.

      Best wishes!

  6. says

    Never really thought about the consequences of a recession being a mere blip for long term investors but that is exactly what it is. Look at a long term chart of the stock market and all past recessions have been minor blips. The market always recovers (sometimes faster than others) and those who rode it out collecting dividend income along the way were the most rewarded. Personally I’m hoping the Fiscal Cliff will give us an opportunity to buy some great companies at great prices. So far though the market seems to be going up rather than down! Guess we’ll see what happens January 2nd.

    • says

      Dan Mac,

      Great stuff there. I remember seeing the 100-year DJIA chart when I first started investing and trying to point out Black Monday. It was pretty much impossible. Of course, in 1987 it sure felt like hell on Earth I’m sure. But now, not really. Funny. Time heals all wounds, no?

      I’m with you. I’m hoping the cliff, or lack of cliff…or the talk of a cliff…or whatever ends up happening or not happening provides us with some fantastic opportunities. I think whether or not we actually go over this thing matters not. In the long run we need some type of stable fiscal plan, and if it doesn’t happen by negotiation than so be it. Of course, I anticipate a pretty serious drop in the market if that happens and I’ll be anxiously scooping up shares.

      Best regards!

  7. says

    Thanks for linking to my piece, DM. I’m honored. And you are absolutely right, it is a blip for those focused on making money long-term in the market.

    Ignore the noise.

    • says

      jlcollinsnh,

      Hey, I’m honored you took the time to stop by. Thanks for commenting.

      A blip is right! As I commented above, Black Monday is most certainly a blip on the 100-year DJIA chart. I’d challenge someone to take that chart and actually try to point out tax changes and government spending changes just based on the chart itself. It’s impossible. The march upwards will continue.

      Take care!

  8. says

    Hey Mantra,

    Interesting post! I’m glad to see you didn’t stop a few weeks back and take the rest of the year off. I never miss one of your articles.

    While I certainly agree the fiscal cliff fiasco or even the recent recession to a large extent are “blips” on our radar, I really can’t stand idle with your stance on taxes. Truthfully, I cringed when I read these sentences:

    “I seek to maximize my potential passive income…I do not, however, seek to avoid taxes. Seeking an investment strategy to avoid taxes would probably involve stuffing cash under your mattress.”

    Maxing out a Roth IRA and contributing to a tax-advantaged 401(k) are really amazing ways to set yourself up for tax advantages. And the different between a taxable investment account and the aforementioned investment vehicles are quite significant. While your method of taxable dividend growth investment continues to eat away at your returns due to the power of compound taxes, my Roth IRA grows tax free while my 401(k) reduces my current tax burden, helping me pay less taxes on an annual basis.

    It’s true that dividend-paying companies with histories of faithfully raising dividends will help boost your share counts as you inch closer to retirement at 40, but when you’re paying anywhere from 15-35% of your take home dividend disbursements to Uncle Sam, surely it must be clear that you’re not taking full advantage of investment vehicles that assist with tax avoidance, right?

    From our previous conversations, I know your goal is to retire at 40 (which is a noble aspiration which I’m quite jealous of, by the way) but couldn’t we agree that a combination of a taxable investment account alongside a Roth IRA (which could be withdrawn after 20 years of retiring at the age of 40) help you keep more of your hard-earned money in your possession?

    I’m curious to hear your thoughts on this. I really truly find it highly significant to avoid paying taxes in order to keep more of your net worth while letting it compound. I’m not sure how giving such a high percentage of your earnings — not only from your paycheck but also from your taxable investment account as it grows so quickly to significant heights — fits in with the idea of doing our best to hold significant wealth prior to retirement.

    • says

      Pey,

      Long time, no see. Glad to see you around!

      Well, the key thing is that the quote you used was “avoid taxes”. Minimizing them, as always, is highly attractive. Again, I’m not cheerleading higher taxes, nor do I look forward to writing the IRS a giant check at the end of the year.

      However, there are some disadvantages even with minimizing taxes through tax advantaged accounts. The key takeaways are as follows:

      First, taxes will, as always, be paid somehow. A ROTH requires the taxes on the investment capital to be paid out on the front end, as it’s net income going into the investment vehicle. A 401(k) will force you to pay taxes at a later date upon withdrawal, albeit hopefully at a lower rate due to one likely needing/having less income in retirement. A 401(k) comes with the added advantage of reducing your income burden now. These accounts, however, require rather long lockup periods of my investments as well, particularly any gains on the initial capital.

      For someone like me, however, who is trying to retire/become completely financially independent by 40 years old these accounts don’t really fit my strategy.

      I need every single penny in my taxable account, funding my Freedom Fund, to give myself the best possible chance of actually meeting my goal and being able to retire from full-time work by 40. If I were to deviate from this rather aggressive strategy, and start using even just 10-15% (that’s on the rather low end if we’re talking both a ROTH and a 401(k)) of my available capital to fund traditional retirement accounts, I would likely not reach my goal. As is, my calculations have me meeting my goal, but not with a giant margin of safety. I’d also like the flexibility of working part-time before 40 if I’d like, and that kind of flexibility would require a decent chunk of my expenses being taken care of by passive income.

      I’m not saying tax-advantaged accounts are anything less than a fantastic financial tool, but rather as many things in life – it all depends on an individual’s situation.

      I’ll be retiring on a rather low amount of dividend income (likely less than $20k/year), so my tax burden, overall, will be very small. Dividends come with no payroll tax and the Federal burden, at such a low rate, will be minimal. Also, I live in Florida where there is no state income tax. I purposely moved here (as mentioned in a very early article) knowing that, so minimizing taxes are not lost on me.

      I’m seeking to avoid high tax burdens, but just in a different way than you. Instead of locking up my capital for many years and hoping I live to see it, I’ll be retiring on a rather low amount of dividend income due to my frugality, and hence be facing rather small tax bills on a recurring basis.

      Also, if I am able to actually reach my goal, my dividend income will likely grow beyond my ability to spend it. I’ll also likely be receiving Social Security (assuming it’s still solvent) when I’m much older…so I shouldn’t be desolate in old age.

      More than one way to skin a cat, as always.

      Best wishes!

    • Chad says

      I have to partially agree with Pey. I believe that you’re missing a great opportunity by not funding a ROTH IRA. With you being 8 years from retirement (I believe this number is right), you can put $5k for 2012 and then $6k for 2013 and each additional year until you retire. If you do this for the 8 years, you’ll have $47k in contributions.

      At 40 when you retire, you can start pulling the dividends from the ROTH. Since you’re pulling your “contributions”, it will take you a long time before you pull out the $47k and then start having to hit the “gains”. By this time, you’ll be over the age to where you won’t have to pay a penalty.

      Since you want to retire at 40, I think you’re doing the right thing by not investing in your 401k. But not investing in the ROTH IRA is costing you quite a bit in future tax savings on the dividends. Also, you can avoid some foreign taxes by the stocks being in a tax deferred plan. Check first before putting in any stocks that do pay foreign taxes to be sure.

    • says

      Yes, that’s exactly my point, Chad.

      There is certainly more than one way to skin a cat, but inevitably one way will take longer. Let me give you an example to strengthen my point.

      In 2013, let’s say you earn $7,330 from your job and you decide to invest this money. After paying a hypothetical 25% tax rate, you’ll end up with about $5,500 for investment.

      Let’s say you put this money in a taxable account, as you’ve been doing. Each year, let’s also assume the company you purchase pays a 5% dividend and dividend tax rates are at 15% (which is incredibly unlikely moving forward). Here’s how this plays out over five years, leaving out capital gains entirely:

      Year 1: 5500 + 275 dividend – 41 taxes = $5734
      Year 2: 5734 + 287 dividend – 43 taxes = $5978
      Year 3: 5978 + 299 dividend – 45 taxes = $6232
      Year 4: 6232 + 312 dividend – 47 taxes = $6497
      Year 5: 6497 + 325 dividend – 49 taxes = $6773

      Now let’s do the same exercise with a Roth IRA:

      Year 1: 5500 + 275 dividend = $5775
      Year 2: 5775 + 289 dividend = $6064
      Year 3: 6064 + 303 dividend = $6367
      Year 4: 6367 + 318 dividend = $6685
      Year 5: 6685 + 334 dividend = $7019

      You end up with an extra $246 in your account after five years of no additional contributions. Plus I didn’t account for dividend rate increases, which would only strengthen my point.

      Lastly, and this is a really big argument for Roth IRAs, if you purchase MCD at $88 and it ends up being 3-5 times higher in 20 years — let’s say $352 a share — you’ll be responsible for paying the capital gains tax, whatever the rate may be in 20 years, if you ever decide to sell in a taxable account. With a Roth, you wouldn’t have to as you’ve already paid the taxes prior to purchasing the shares. This point is huge and cannot be ignored.

      Despite the fact your time horizon is quite short, it still makes much more sense to utilize a Roth for the near term and long term in order to save much more of your hard-earned cash. Having 100% of your investments in taxable accounts is not a wise move if your goal is to retire as quickly as you can and will prolong things here in the so called rat race.

      We may continue to debate this point for years to come but I hope you’ll eventually see that you will be paying a significant amount more in taxes by not utilizing a tax-avoidance strategy, such as a Roth.

    • says

      Pey,

      Great points there. Again, I’m not disagreeing with you. A ROTH IRA can be a fantastic financial tool, as I said above.

      Using today’s numbers, however, I still do not believe that a ROTH will magically turbocharge my tax effectiveness.

      Based on the amount of dividend income I’ll be living off of (likely less than $20k), using current tax income rates I’ll actually owe $0 in taxes on qualified dividends even while holding these investments in a taxable account. Of course, this can (and may) change at any time. But, we only have current numbers to base our decisions on. So based on owing $0 in federal taxes based on a marginal tax rate of 15% and qualified dividends being essentially tax-free at that level…a ROTH IRA will save me nothing.

      Again, I’m basing my strategy on a rather frugal lifestyle and living off a relatively small amount of dividend income. Someone earning $50k in dividend income per year is obviously much more inclined and motivated to reduce their tax bill however possible. When you’re earning less, you’re paying less in taxes. Plain and simple.

      Even if I were to change my mind and start maximizing my ROTH contributions starting next year, I’d have 9 years to contribute $5,500 (at 2013 caps), which compounding at 7% I’d have something a little north of $70k at 40 years old in my ROTH. Factoring in a portfolio-wide dividend yield rate of 3.5%, I could start taking out my “contributions” as dividends and earn $2,450 from these withdrawals. Factoring in a 15% tax rate (which, as pointed out above, for me is incorrect) I’d be saving $367.00 annually in tax burdens. While that’s certainly nothing to sneeze at, it’s also not exactly life changing. If I truly felt that $400 or so a year was going to negatively affect my plans I’d probably just work an extra month past my 40th birthday, and at my current income rate I could cover about 10 years of tax burden due to the lost opportunity cost of the dividend income that would have come from a ROTH.

      If tax rates change dramatically from here, a ROTH could make sense and I’m open minded to changing my strategy and the ways I go about doing what I’m doing. But, simply based on my specific strategy, my specific numbers and my specific plan a ROTH just doesn’t offer me anything substantial. If dividends are taxed 10 years from now as they are today I’ll be paying no payroll tax, no federal tax and no state income tax regardless of whether part of my Freedom Fund is located in a ROTH or not.

      I think, however, you made a great point about capital gains and the ROTH. That’s probably one of the best reasons to invest in one. However, as I pointed out in the article “my favorite holding period is forever” and I stay true to that. I don’t sell often, and I quite honestly plan to sell considerably less than I already have.

      Again, I applaud what you’re doing and I think that for 99% (or more) of people out there a ROTH IRA is a fantastic investment arrangement.

      Something I alluded to above, and didn’t expound upon was my in-the-back-of-my-mind thoughts on possibly leaving the full-time rat race before 40 and just shifting to a semi-retirement and working part-time for a couple decades or so. My taxable Freedom Fund would allow me the flexibility of doing this if I’d like and still keep my income down to a level that is minimally taxed.

      Best wishes!

    • says

      I would have to say ditto to Chad’s response. Even if you wouldn’t hit the tax benefit of the Roth right now, who knows what the future will bring, it doesn’t hurt to put it in now though. You won’t be able to go back in time to put your contributions in.
      I think another factor is you might want to diversify your portfolio between more than one broker, starting a Roth with someone else would do that for you also.
      I am looking for a bit bigger portfolio dollar-wise myself and will spread it over 3 or 4 based on SPIC insurance limits.

  9. says

    Dividend Mantra,

    Great point that your intended holding period is… forever. I have to start thinking that way too. I’m in it for the financial independence as well.

    And yes, to make more money, we’ll have to be okay with paying more taxes. I’ll gladly take a tax hit if it means I’m raking in the dough.

    As for the fiscal cliff, it doesn’t really scare me either. I’ve been reading jlcollinsnh and I’m ready to weather whatever storm comes at me with the market.

    • says

      Kraig,

      Thanks for stopping by!

      I’m with you. I’m not advocating paying more taxes, but if that burden comes with the fact that I’m making more money…then so be it.

      I’m glad you’re reading jlcollinsnh. He has fantastic advice, even if it differs from mine. His writing is really phenomenal. His engaging demeanor is one I wish I could replicate rather frequently.

      Stay in touch!

      Best regards.

  10. says

    I think the real problem with the fiscal cliff isnt the resolution, but whether the resolution to it will actually address the huge debt and spending problem the US faces. There will be some sort of deal. But the nitty gritty of that deal might be worse than no deal if the powers that be look at it and come away unimpressed. A credit downgrade might be coming.

  11. says

    Also wanted to chime in on the tax deferred debate. I am always suprised no one ever talks up a regular IRA. Not only does it grow tax deferred, but you get a tax deduction for using it…I chip in 5k to my IRA, and 11% of my gross pay to my 401k, that comes out to over 12k in income deductions…taking me to a lower bracket easily even before I add anything else. I see the benefits of a Roth, of course, but those benefits are in the future, the traditional has benefits that help you right now, which is what many people currently need. Also, to the commenters above, the Roth has attracted probably billions in assets over the years, there is no guarantee the US wont tax it at some point with all the problems we face…this is one reason the fiscal cliff talks do matter, because if these problems dont get solved, who knows what actions once thought unthinkable might follow?

  12. says

    DM,

    Thanks for the shout out, I appreciate it! I also admire your devotion and dedication to dividend growth investing. It will take persistence to succeed, and you have that in spades.

    Happy hunting my friend!

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