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Don’t Divorce Dividends Ahead of the Fiscal Cliff

Every day Jim Cramer scours the Street, looking for new ways to make money. An essential part of that quest involves forming a thesis and then doing some hard hitting research.

That's where top researcher Nicole Urken comes in. She's one of the best in the business and practically Jim Cramer's right arm.

The two swap messages countless times throughout the day. Following is one such exchange involving dividend investing and the impact of a sharp increase due to the fiscal cliff.

From: James Cramer
Sent: Wednesday, November 07, 2012 10:22 AM
To: Nicole Urken
Subject: Dividend Investing

What were dividends and cap gain tax rates under Clinton (when rates were higher). That's a good place to start.

Nicole Urken, Mad Money Research Director

From: Nicole Urken
Sent: Wednesday, November 07, 2012 12:08 PM
To: James Cramer
Subject: RE: Dividend Investing

The dividend tax rates went from being taxed at the income tax rate (part of ordinary income) to 15% in 2003 (part of the Bush tax cuts). The capital gains tax rates went from 28% to 20% in 1997 and then from 20% to 15% in 2003 (Bush tax cuts)

Fiscal Cliff
Steve McAlister | Photodisc | Getty Images

Nicole's Analysis

As fiscal cliff worries continue to dominate headlines and move the markets, many analysts have been scratching their heads in particular to quantify the effect a potential increase in the dividend tax would have on yield oriented equities. We have seen the issuance of a number of special dividends just in the last couple of days—including Ethan Allen, Dillard's ,Brown-Forman and Las Vegas Sands —likely in large part to avoid the threat of pending tax increases. Read More: Fiscal Cliff - America's Looming Economic Crisis

So what now? What do you do with your dividend stocks?

Right now, the consensus among many analysts is that the dividend tax rate is an issue where politicians may be likely to find common ground. Most likely, dividend rates will increase to 20 percent to be on par with capital gains taxes—averting a shift away from yield-oriented investments.

While a change in tax code may create a temporary move away from high dividend names, over the long-term this effect should not be so stark and some of these concerns are already priced in. A recent Bank of America analysis suggests that taxes did not play a significant role in explaining the performance of dividend oriented strategies, looking before and after the Jobs & Growth Tax Relief Reconciliation Act of 2003.

On Monday, in Morgan Stanley's upgrade of US equities, they cited yield oriented equities as one of the underpinning drivers behind their increased bullishness. Fears about dividend tax rates remain, but ultimately we have a number of key drivers that make this cohort attractive nonetheless.

First off, we are living in an extremely low interest rate environment—which will be in place for some time. With equity yields more attractive relative to bond alternatives and the ten-year, income oriented investors will still remain interested in dividend yielding stocks.

Second, we are seeing secular growth toward more income-oriented equities. Retiring Baby Boomers are swapping growth (capital appreciation) for income … ie searching for yield where there aren't many alternatives. After all, over the next 20 years, the US Census Bureau forecasts that the percentage of the US population that is older than 65 will double. Not to mention that the economy, while in recovery mode, is still feeble and bumpy—meaning that holding more defensive oriented stocks (with dividend yields) are an important component of equity strategies.

Third, the payout ratio of dividend paying stocks is near a historical low. With cash on company balance sheets at a very healthy level (non-financial US equities have over $1.5 trillion at their disposal, according to Morgan Stanley), corporate cash return strategies remain highly likely.

Fourth, managements are increasingly paying themselves more in restricted stock units, making dividend increase increasingly likely.

Of course, there will likely be some trading effect when get a decision on dividend taxes, but you shouldn't run for the hills and sell all your dividend stocks.

In particular, it is key to look for companies with room to increase their dividends because of earnings power and strong balance sheets versus companies with sky-high yields. Dividend growth ultimately leads to higher dividend yield. Earning power and the health of the balance sheet remain key—particularly when it comes to income-oriented names, you want to avoid ones with dividend risks like Exelon which had been beaten down, orWindstream where worries remain.

The bottom line: Don't run away. We have always emphasized the power of dividends on Mad Money. Remember, over 40 percent of the total equity market performance in the US over the last century has come from dividends. Tax laws have varied considerably over that period—so that's solid precedent to keep dividend investing in your consideration.

Follow Nicole Urken on Twitter @nicoleurken

Call Cramer: 1-800-743-CNBC

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