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3 reasons to fear a dividend tax hike

February 28, 2012 — MSN Money — By Abram Brown   Bookmark and Share

President Barack Obama's proposal to raise the tax on dividends should leave investors trembling. It has the ability to affect anyone with an interest in equities, from the executive in the corner suite to the grandmother who lives next door to you.

You pay 15% on dividends right now. Under Obama's plan, the wealthiest would see a personal tax rate of nearly 45%. And before a company gives a dividend, that money is taxed as corporate profit. Obama would like to lower the corporate tax rate to 28%.

So, by the time the dividend reaches your bank account, it has been taxed twice.

The corporate dividend tax hike is part of Obama's broader restructuring of America's corporate tax structure. As a whole, the plan would be a game-changer for U.S. business. But the dividend tax increase is the plan's most striking element, since it's hard to identify who it would help.

Here are three reasons to fear the Obama plan:

1. It could hamper the shelter behind dividend stocks.

A high-yield dividend stock can provide some comfort and stability in volatile times -- a period like the one we're in right now. (Post continues after video.)

If each new day brings a wild swing in the equity market, being able to count on a dividend can seem like a good way to take cover. Money managers can direct clients toward blue-chip companies with sizable dividend yields. Stalwart Coca-Cola just raised its dividend for the 50th straight year.

Now, you don’t invest in these types of companies to make money through appreciation or trading, says Mark Lamkin, who manages $250 million at Lamkin Wealth Management. You pick these stocks for their security -- and their dividends. But, if those dividends lose their value through higher taxes, these stocks lose their attraction.

2. It could increase market volatility.

To make up for what you lose in dividends, you'd probably start trading more. Greater volume can bring volatility. And don’t we have enough volatility as it stands?

It would also lead to some investors entirely sitting out, reducing the amount of available capital.

"As you increase tax on dividends, you discourage some amount of investment in stocks," says David Stowell, a former UBS managing director. "As you discourage investment in stock, there’s less money to fund companies to produce useful products, to employ people, and I think it really takes some money out of the economy. It certainly seems counterproductive to building a more robust economy."

3. It could hurt retirees the most.

Americans 65 and older accounted for 42% of dividend income reported to the IRS in 2008, the latest year available.

So, when Obama suggests raising the tax rate on dividends, he's taking aim right at your retirement nest egg.

Your retirement portfolio probably has a lot of dividend stocks right now because they're predictable. But with higher taxes, money managers would likely shift more toward growth companies and away from dividend-bearing stocks. This is all well and good until that growth stops, says David Armstrong, who manages $200 million at Monumental Wealth Management.

What would be likely to halt it? Well, if there was anything remotely like 2008 in the future, that would cause a pretty big jolt.

This post is by Abram Brown of Forbes.com.