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Dividend Taxes – What’s in store for 2011?

Saturday, July 03, 2010

A key question looming on the minds of dividend investors and the stock market in general surrounds the taxation of dividends in 2011.

By way of context, dividends are taxed at the corporate level – as income, as well as at the individual level. This results in double taxation, and has long been fodder for philosophical debate over the fairness of the system. One school of thought holds that individuals should not pay taxes on dividends at all, because they’ve already paid as partial owners of the companies in question.

 In 2003, President Bush signed a tax reform bill into law that brought the dividend tax rates down from the standard wage tax rate.  For “qualified” dividends, taxes were paid at a rate of either 5% or 15%.  Lower income taxpayers saw qualified dividend rates drop to 0% in 2008-2010.  This rate structure mimics the long-term capital gains rates.  Note:  qualified dividends are paid on stocks held for all of the 120 day period around the ex-dividend date, which is the date on which the shareholder base is determined with regard to who will receive dividends.  In other words, if a shareholder owns the stock on or before ex-dividend date, he or she will receive a dividend for that period.

The 2003 cuts were significant, as the top tax bracket had dividend taxes cut from 35% to 15%.  Perhaps more importantly, the two lower brackets dropped from 10%/15% to not paying any taxes on dividends.  Unfortunately, the dividend tax rate is set to expire beginning January 1, 2011.  At that point, taxes on dividends will revert to the rates paid on wages.  Right now it is unclear what will actually happen at that point, however.

Simply extending the lower dividend rate seems like an option.  However, that would be considered a tax cut, which would require Congress to justify under PAYGO rules.  In short, the higher rates are factored into our federal revenue projections, and we’d have to pay for lower rates – even in the case of an extension – by cutting spending or raising revenue somewhere else.

Undoubtedly, any plan to raise taxes on dividends is designed to raise revenues to help pay for the dramatically increased government spending that has taken place over the last decade.  However, in its most extreme form, an unintended consequence could be to weaken the balance sheets of US corporations, such that they are less well equipped to deal with economic downturns.  That is because raising taxes on dividends could incent corporations to use debt instead of equity.  At least, it may dis-incent them to use equity, as the tax would be the same on interest payments as on dividends.

Furthermore, the recent health care bill already includes an additional 3.8% tax on investment income beginning in 2013.  This includes dividends.  So the rate is going up, one way or another.

What makes this a particularly stick situation is that the dividend tax decision impacts the wealthy as well as lower-income taxpayers.  Per a  Wall Street Journal report, the Tax Policy Center estimates that six million lower-income households will return to paying taxes if the Bush administration changes are simply allowed to lapse. Most Republicans, many Democrats, and President Obama have all stated that they believe dividends should be taxes at the lower capital gains rate, rather than standard income tax rates.

Bottom line

It is still anybody's guess as to how this will play out for taxpayers.  How will it play out for investors? Certainly, dividend stocks are more attractive under the current taxation plan than they were when dividends were taxed at the standard income rates.  However, the outsized returns achieved by dividend stocks that I highlighted in a previous blog post were  were largely gained under non-preferential tax rates.  Consequently, the argument for dividend stocks outperforming the market over the long-term remains strong, regardless of the direction of dividend taxes.  Within reason, of course.

Tags: dividends, dividend taxes, 2011

Investing | Stocks | Taxes

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Do Dividends Matter?

Wednesday, June 09, 2010

Pretty much all finance students are confronted early in their educational career with the question of whether or not dividend policy matters to the value of a stock.  Specifically, a paper written by Professors Merton Miller and Franco Modigliani argues that it does not matter.  Without boring anybody with the gory details, it’s worth exploring what that means for investors.

Many in the investing world view dividend stocks as the province of “widows and orphans”.  At least some of the time, it is an accusation.  Fair enough.  It’s hard to argue that these equities don’t serve as a source of stability in bad markets.  After conducting a study of his own, Wharton professor Jeremy Siegel finds dividend stocks to be effective “bear market protectors”.

What’s particularly powerful is that not only do dividends provide a measure of protection in the form of a consistent payout, they act as a “return accelerator” when they are reinvested in down markets.  That is because the stocks are priced lower than they would be in a bull market, so the reinvested dividend is buying shares at a relatively low price.  Those additional shares in turn accelerate the investor’s performance when strong markets return.

By way of example, Siegel cites the fact that it was not until 1954 that the S&P 500 returned to the level of values it held prior to the Stock Market Crash of 1929.  However, those who reinvested their dividends through that period were 60% better off in 1954 than they would have been had the crash never happened.  That’s a powerful accelerant.

Great, you say, but what about bull markets?  Well, one school of thought would be that preserving capital during bad markets in exchange for slower growth during good ones is a reasonable tradeoff.  I would agree with that.  Take, for instance, the investor who lost 60% in 2008, but gained 103% in 2009.  (That is the precise performance of a small-cap fund I reviewed for a 401k plan this morning).  If an investor had $10,000 on January 1, 2008, he would have had $4,000 on December 31, 2008.  After the spectacular run up in this particular fund in 2009, the investor would have ended the year at…$8,120.

In reality, though, over long periods of time, in good markets and in bad, dividend stocks outperform the overall market.  In Jeremy Siegel’s study, he was surprised to learn that the highest yielding stocks, or those paying the highest dividends, generated between 2.5% and 4.5% higher returns than did the overall market.  If that difference seems paltry, I invite you to review an earlier post outlining the dramatic difference that small increases in return can produce.

In a 2003 article in the Financial Analysts Journal title Dividends and the Three Dwarfs, Robert D. Arnott demonstrates the importance of dividends to the long-term benefit of owning stock.  Arnott points to numbers that detail stock returns from the 1802-2002.  How’s that for a long-term test?  The average annual return for stocks over the 200-year period was 7.9%, of which dividends accounted for 5%.  That’s 64% of the return!  Other studies cover other periods of time but still reach the same conclusion:  high-yielding stocks perform better than the overall market.

Do dividends matter?  In a word, yes.

Tags: dividends

Investing

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