If it's dividends you seek, consider many factors

Dollars & Sense

January 19, 2003|By David Kathman | David Kathman,MORNINGSTAR.COM

What kinds of investments would be more attractive if double taxation of dividends gets cut or eliminated altogether?

This question actually arose on our message boards, but it's worth addressing here because of all the attention being given to President Bush's economic plan. As you've probably heard, a significant part of that proposal involves making stock dividends from companies that pay corporate income tax tax-free for shareholders. Here's some background, along with some opinions as to what it all means.

Dividend yields these days are lower than ever, and a lot of people have laid at least part of the blame on the U.S. tax code. Corporations have to pay taxes on the money they pay out as dividends, and shareholders then have to pay taxes on that money after they receive it; thus, it's taxed twice. Furthermore, income from dividends is taxed as ordinary income, whereas capital gains are taxed at a lower rate, making them more desirable for shareholders.

These tax rules have been significant factors in the decline of dividends over the past couple of decades, although other factors are at work. There's been a general move away from returning money to shareholders directly through dividends (with the accompanying tax burden) and toward returning it indirectly, through such means as share buybacks. In fact, a lot of the money that companies used to spend on dividends now goes toward buying back stock, which theoretically boosts the share price.

But the brutal bear market of the past three years has made dividends look a lot more attractive, since they're paid rain or shine, regardless of the market's gyration. (Well, usually they are - see below.) That doesn't mean the president's plan hasn't attracted controversy, as any tax-cut proposal will.

Even among those who agree that the double taxation of dividends should end, some critics argue that dividends should be tax-free not for shareholders, but for corporations (i.e., through tax deductions). That way, companies would have a stronger incentive to pay dividends.

Under the Bush proposal, not only would companies have no such direct incentive, but people who hold stocks in tax-sheltered accounts would have no reason to demand dividends. I tend to agree with such arguments, though in this post-Enron climate, a tax break perceived as benefiting corporations would be much tougher to sell than one perceived as benefiting shareholders.

Politics aside, I think encouraging companies to pay dividends (by whatever means) is a good thing for the long-term health of the stock market. Dividends are tangible, and companies can't fudge them as they can earnings - either a company pays out the dividend it promised, or it doesn't. Lots of firms that don't pay dividends probably should, particularly if they can't generate a return on that money that's higher than their cost of capital. Plenty of money has been wasted on ill-conceived mergers and projects when it could have been returned to shareholders to do with as they please.

If the president succeeds in eliminating taxes on most dividends, what will it mean for you? Most obviously, you'll benefit if you own dividend-paying stocks in a taxable account. These are good characteristics to look for: companies with wide moats, dividend yields above 2 percent, five straight years of dividend growth and 10 straight years of free cash flow.

A high dividend yield is a positive, but you want to make sure that the company is stable enough to keep paying its dividend. A similar but broader list is Mergent's Dividend Achievers, consisting of companies that have increased their dividend in each of the past 10 years.

Other factors should be taken into consideration as well. We excluded REITs (real estate investment trusts) from our list, and with good reason. REIT earnings are already not taxed at the corporate level, so REITs are unlikely to be included in the Bush proposal and may actually be hurt as investors turn toward other income-producing investments. Among non-REITs, financial health is also important; companies with tons of debt and little cash may be more likely to cut dividends in the future in order to shore up their balance sheets, especially if they have operational problems.

Then there's the question of mutual funds. Investors who own mutual funds with a lot of high-yielding stocks would benefit, since the income distributions they receive from those funds would presumably become tax-free under the Bush plan.

But the fund's expense ratio also comes into the picture: Because funds subtract their operating expenses from such distributions before those distributions reach shareholders, owners of low-cost funds would reap greater tax benefits. (For example, shareholders of a fund such as Vanguard Equity-Income, which has a yield of 2.6 percent and an expense ratio of just 0.47 percent, would benefit from the plan.)

Of course, a lot depends on whether the Bush tax-cut plan goes through (it's still far from a sure thing), and what form it takes if it does. I wouldn't want to buy any stock just as a bet on the elimination of dividend taxes. But if you're looking for income anyway, the proposed changes would probably help.

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