Before I go on, let me tell you who will get these cuts. They’ll go to investors who own stocks and mutual funds outside retirement plans (that’s 21.3 percent of families for stocks and 17.7 percent for funds). High-income people will cop the lion’s share of the money. You get zip for investments in 401(k)s, IRAs and other tax-deferred accounts. But retirement accounts still trump tax-free dividends, thanks to the tax deduction and employee match.
A dividend is a cash distribution to shareholders, paid out of profits after tax. But not all dividends are freebies under the president’s plan. A company can distribute, tax-free, an amount equal to the federal tax it pays. Anything more will be taxable to shareholders. If your company avoids taxes, you get to pay, instead.
The same rule holds true for companies, of any sort, that don’t distribute dividends. They have to pay taxes in order to pass a cut in the capital-gains tax along to you. As an example, assume that the company has enough profit to pay out 26 cents a share but chooses not to. You’ll get a credit for that amount. When you sell, the 26 cents won’t be taxed as a capital gain.
You may think it’s a great idea for a company to hoard its cash so it can reinvest in new businesses. But let’s face it: CEOs with huge honey pots have made some lousy decisions–acquiring companies on whim, paying too much for them, frittering billions of dollars away, says New York economist Peter Bernstein. Dividends impose discipline when it’s needed most.
They can also be lucrative. As you probably know, since 1920, stocks have returned an average of 10 percent a year. But were you aware that price appreciation accounted for only 6 percentage points of the gain? Reinvested dividends supplied the rest, according to Charles Jones and Jack Wilson of North Carolina State University. Today, dividends are running at a meager 1.8 percent. Jones and Wilson expect total stock returns of no more than 8 to 9 percent over the next 10 years, solely because dividends have dropped so low.
Looking back over stock-market history, Bernstein finds that high dividend payouts precede years of high earnings growth for stocks. Low dividend payouts, as we have today, precede low-growth years.
Assuming that Congress leaves at least part of Bush’s plan intact, Wall Street will respond with a blizzard of products touting income and safety, says Don Cassidy, senior research analyst for Lipper, which tracks mutual funds. Here’s what’s on offer now (remembering that some of these dividends won’t qualify as tax-free):
Dividend-paying common stocks. A reasonable yield is 3 to 6 percent. (Stay away from 7 to 10 percent yields. Those stocks have plunged in price and their dividends could be cut.) Good candidates are utilities–and here, you’re definitely looking for your grandfather’s stocks, says Lowell Miller of Miller/Howard Investments. You want boring companies that deliver gas and electricity to consumers, and perhaps produce it, too. “We like rising dividends, plain and simple. That’s the requirement for us to recommend a utility stock,” adds Brian Youngberg, an analyst at the brokerage firm Edward Jones. By the way, these stocks droop when interest rates rise.
You won’t want to hold dividend stocks in a margin account. You’d lose your tax break, if you borrowed against them.
Equity-income mutual funds. These funds specialize in dividend-paying companies. Their average current yield, however, stands at only 1.7 percent, after expenses are deducted. The fund would have to tell you how much was taxable each year.
Preferred stock (so called because the dividend has to be paid ahead of any dividends due on the common stock). Traditional preferreds are paying 5.5 to 6.5 percent, and could be tax-free. Their market price rose by 5 to 7 percent in recent weeks, says Donald Crumrine of Flaherty & Crumrine in Pasadena, Calif., which advises two Preferred Income funds. These stocks, too, decline when interest rates go up.
There are also funds for stocks known as hybrid or trust preferreds. For complicated reasons, their dividends won’t be tax-free, says Ted Neild, managing director of Nuveen, which has three of them.
Dividend reinvestment plans. More than 1,000 companies offer plans that let you use dividends to buy additional stock. For more information, check fool.com or moneypaper.com.
Tax-free municipal bonds. Their yields will look low, compared with tax-free dividends on stocks. But stocks are riskier, so they’re no substitute for bonds.
Microsoft. It just declared its first dividend–16 cents a share, for a piddling.3 percent yield. But not a piddle for Bill Gates, owner of 612 million shares. His take will be $97.9 mil–potentially tax-free.
