Dividend Investors' Looming Catch-22

Washington’s tax fight puts dividend investors in a tough spot.

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The threat of rising tax rates has set off alarm bells among investors who rely heavily on income from dividend-paying stocks. But comments Tuesday from Federal Reserve Chairman Ben Bernanke are bound to give dividend investors pause before fleeing to the exits.

Speaking in front of the Senate Banking Committee, Bernanke warned of sustained periods of slow growth in the domestic economy. Going further, Bernanke also spoke of a "modest" deflationary risk.

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"I think inflation risk is relatively low now. Not everyone agrees with that, but my personal opinion is that that risk is reasonably low right now," he said. "And indeed ... there is a modest risk—not a large risk, but a modest risk—of going in the other direction, which is towards the deflationary side."

For investors, this creates something of a Catch-22. On the one hand, with the expiration of the Bush tax cuts in 2013, the top tax rate on dividend income could soar to 39.6 percent. In other words, dividends would be taxed as ordinary income. At the same time, dividends have long been a safe haven when fears of slow growth and deflation loom on the horizon. That is because their steady stream of income has traditionally provided a much-needed buffer in times of economic malaise.

So what's an investor to do? For starters, patience is a virtue. Macroeconomic conditions are not going to change overnight, but tax proposals frequently do. At the moment, it's anyone's guess what will happen to dividend tax rates come 2013.

As has perennially been the case, the Bush tax cuts are the subject of intense inter-party bickering. To complicate matters, however, there are also intra-party divisions on the future of dividend rates. President Obama, for instance, favors treating dividends as ordinary income. Senate Democrats have balked, however, and favor capping dividend tax rates at 23.8 percent.

It goes without saying, of course, that this spread—23.8 percent vs. 39.6 percent—is quite broad. And that's just the spread among the Democrats' plans. Another possible outcome is that rates will remain exactly where they currently are.

[See The Benefits and Pitfalls of Dividend Stocks.]

The bottom line is that nobody can predict with any certainty what will happen to rates. Right now, the only thing that's entirely clear is that passions will run high. Election-year politics and tax debates have traditionally been explosive bedfellows, and this cycle has been no exception.

For long-term investors, the tax debate will be a relatively short one to wait out. If the tax surge actually does materialize, it may be worth considering ditching dividend-paying stocks. But a rush to dump such investments in anticipation of a hike seems premature.

While some would argue that Bernanke's concern about deflation is alarmist, most would agree with his portrait of a struggling economy. These struggles are compounded, at least in the short term, by talk of a fiscal cliff. Bernanke acknowledged that threat Tuesday, remarking that "we do anticipate that the uncertainty associated with the so-called fiscal cliff will have some economic effects."

With such uncertainty hanging over investors' heads, dividends seem particularly attractive. Indeed, in the event that tax rates remain constant, even investors who are currently running for the exits will likely want back in. Consequently, before selling your dividend investments, consider this: Trading costs are expensive. Moving in and out of investments based on the machinations of the political process is a dangerous game for most investors to play. Before making any big decisions, it may be worth seeing how the tax debate plays out.

[See One Reason Not To Buy Dividend-Paying Stocks.]

Alternatively, if you're steadfastly of the opinion that Congress won't allow dividend tax rates to rise, the current climate could present a buying opportunity. If anxiety over the political debate causes a selloff in companies known for their dividends, it could lead to artificially depressed prices.