Bush's tax-free dividend plan may not be such a great deal

PERSONAL FINANCE

January 26, 2003|By EILEEN AMBROSE

PRESIDENT Bush's proposal to eliminate the income tax that investors pay on dividends has generated speculation about winners and losers.

At first, it seemed as if the winners would be dividend-paying stocks, especially preferred shares that pay high dividends. Among the potential losers, it seemed, would be tax-free municipal bonds that would face new competition from stocks and 401(k) investors who would still have to pay income tax on reinvested dividends once they took money out of the plan.

But now, it's clear the president's plan is not as simple as tax-free dividends across the board. And if it becomes law, investors will need to carefully decide where their investment dollars will do the most good.

Basically, under the president's plan, corporations would be able to distribute tax-free dividends to shareholders beginning this year - if the dividends are paid with money that's already been taxed.

Dividends, though, might remain taxable or be only partly tax-free if companies didn't pay taxes because of a loss or they paid little tax because of credits and deductions, said William E. Massey, a senior analyst with RIA, a New York tax information firm.

Investors in a company that doesn't pay dividends but plows profits back into its operations would be allowed to increase their cost basis - the price they initially paid for the stock - when they sold the shares, thereby reducing the capital gains tax bite.

"It's not simple," Massey said. "The details keep dribbling out in bits and pieces."

It's too early to make portfolio adjustments based on the plan. After all, Congress still needs to weigh in. "It's a proposal, not an act. I would rather time the market, than time Congress," said Harold Evensky, a Florida financial planner.

Still, investors should be aware of how the plan could affect them. Here are some considerations:

Tax-deferred 401(k)s: The president's plan doesn't change the tax treatment of 401(k)s.

"The knee-jerk reaction on the part of some investors is since all the distributions from 401(k) plans are going to be taxed, then maybe they're not as worthwhile as just simply investing in a regular taxable account where the dividends under Bush's proposal would be tax-free," said Steven Norwitz, a vice president with T. Rowe Price Associates in Baltimore. Not true, he said.

Tax-free dividends would be a boon to taxable accounts, but workers would still end up with more money by investing in a tax-deferred 401(k), according to a Price study.

Price looked at the consequences of investing one's earnings on a pre-tax basis in a 401(k) and on an after-tax basis in a taxable account. The analysis assumes the money is invested in a stock fund with an 8 percent annual return, with about 2.5 percentage points from dividends. The combined federal and state income tax rate is 31 percent and capital gains is 24 percent.

Right off the bat, the 401(k) has an advantage because the earnings are invested before any taxes are paid. In 20 years and after income taxes are paid upon withdrawal, an initial $10,000 investment would have reached $32,324.

The earnings invested in the taxable account are subject to income taxes upfront, reducing the initial investment to $6,935. After 20 years and any taxes on capital gains and dividends, the account would grow to $22,510 under current law. If dividends become tax-free, the balance would grow to $26,123.

It's the ability to invest on a pretax basis, with more money available upfront, that gives the 401(k) a big edge. The Price survey also doesn't factor in an employer's matching contribution, a major benefit of the 401(k).

Many workers can afford to invest only through a 401(k), and the best strategy for them is choosing the right mix of stocks and bonds within the plan based on when they need the money and risk tolerance, said James Angel, a finance professor with Georgetown University.

Those with money to invest outside a 401(k) may want to adjust account holdings if dividends become tax-free. In that case, investors would want to keep taxable bonds in a 401(k) or individual retirement account while putting stocks in a taxable account, Angel said.

Municipal bonds: Unless these tax-free bonds offer higher yields, the demand for them will fall off because they will find it harder to compete against dividend-paying stocks, some predicted. But the impact on municipal bonds has been overstated, because investors will still want them to add stability to a portfolio, others said.

Dividend-paying stocks can still fall in price, they said. And, "dividends can be cut and eliminated," added Catherine Gordon, a principal with the Vanguard Group in Malvern, Pa.

Preferred shares: Not all companies offer them, but preferred shares generally offer more generous dividends than common stock and are expected to get a boost from the president's plan.

But here, too, investors must be wary. Most preferred shares are a hybrid version introduced in the 1990s, and the "dividends" they pay are considered interest and, therefore, won't be tax-exempt, said Douglas S. Rogers, chief investment officer with Deloitte & Touche Investment Advisors in Chicago.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose- @baltsun.com.

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