Worried About 'Fiscal Cliff'? Look Out for 'Income Cliff'

While everyone wonders whether we're about to go over the "fiscal cliff," owners of dividend-paying stocks are bracing for what some are calling an "income cliff."

Worried About 'Fiscal Cliff'? Look Out for 'Income Cliff'
Getty Images

Those who have been counting on dividends as income — often retirees but also higher-end retail investors — could see their tax burden nearly triple if the worst of the "fiscal cliff" is realized.

That will happen if the warring parties in Washington fail to reach agreement on the series of tax increases and spending cuts set to take effect on Jan. 1.

For dividends, it will mean taking the current 15 percent preferential taxation rate all the way up to ordinary income, currently set at 35 percent for top earners but ready to jump to 39 percent if "cliff" talks fail. (Read More: Obama: Let's Get Fiscal Cliff Deal Before Christmas)

Add on the 3.8 percentage point surcharge for the Obamacare health insurance expansion and those holding dividend stocks stand square in the crosshairs, in danger of getting slammed by an "income cliff."

"Investors are very much mistaken if they think that they have the opportunity to kick the can down the road like politicians do," said Erik Davidson, deputy chief investment officer at Wells Fargo Private Bank. "Investors, particularly wealthy ones, face a higher tax situation, no two ways about it."

Like many others in the investing world trying to parse out the negotiations in Washington, Davidson does not expect a full-scale tumble over the cliff.

Instead, legislators are likely to hammer out an agreement that continues lower tax rates for middle and lower earners, patches up the Alternative Minimum Tax and increases taxes on investments but at a lower rate than the onerous levels prescribed by a full-scale cliff situation. (Read More: Buffett Expects 'Fiscal Cliff' Fix, but Not by December 31)

Still, Davidson thinks it's time for investors to take some cover in other assets. He suggests a mix of real estate investment trusts along with corporate, municipal and emerging market bonds.

"Investors have been happy to do dividends. The S&P 500 has a higher dividend yield than U.S. Treasurys for the first time since the 1950s," he said. "It's a good place for people to go for income. Against this backdrop of an income cliff, investors shouldn't be abandoning dividend-paying stocks, but they need to be diversified among other income-producing investments as well."

Dividends had been doing well through the early part of 2012, but the space has become increasingly volatile as the cliff negotiations intensified.

A chart of the Vanguard Dividend Appreciation exchange-traded fund can be traced in close unison with the progress of the talks, reflecting investor unease over the "income cliff."

"Markets just hate the uncertainty," said Nadav Baum, executive vice president at BPU Investment Management. "That's why you're seeing these names sell off."

The dividend issue is especially ticklish because it affects investors who own high-end stocks like the ones that comprise the Dow Jones industrial average.

Dividends get special tax treatment because they come from corporate profits that already have been taxed.

For seniors living off their dividend income, they don't get a direct hit if their dividend stocks are confined to Individual Retirement Accounts, which already are taxed at ordinary income on withdrawals. The impact comes from the lowered values in the stocks if they are sold off during a "cliff"-type scare.

In an effort to assuage that uncertainty of which Baum spoke, nearly 70 companies have issued special dividend payouts before the end of the year, to get under the wire of the possible federal tax trap. (Read More: Companies Shelling Out Billions to Beat the 'Fiscal Cliff')

"We all know taxes have to go higher. Is it going to go to ordinary income? Who knows?" he said. "The reality is if you're going to be a stock market investor, no matter what the tax bracket is going to be I would prefer to own higher-paying dividend companies."

Investors remain hopeful that the impact won't be that pronounced.

In a recent analysis, Deutsche Bank encouraged the two sides in Washington to raise revenue less by increasing taxes and more by cutting loopholes and growing the base of those who pay.

"We find that the gap between the two parties over taxes in the fiscal cliff debate is not large," the firm said. "Such limits on deductions would be painful for many taxpayers that have grown dependent on them, but the pain of such a compromise would be much less than that incurred in going over the cliff."