Archive for Sunday, January 19, 2003

It’s too soon to hunt for dividend-rich stocks

January 19, 2003

Advertisement

Now that President Bush's long-awaited tax cut proposal has arrived, what should you, as an investor and taxpayer, do to make the most of it?

Short answer: nothing.

For starters, Democrats in Congress are on the warpath, crying the plan is yet another giveaway to the rich. Even some Republicans have muttered doubts, worrying that a $674 million tax cut would worsen the federal budget deficit.

So there are sure to be big changes before anything becomes law -- making it impossible to plan now.

There's certainly no reason, for example, to postpone doing your 2002 income taxes. If some final provision does affect your bill for last year, you could file an amended return. It doesn't make sense to dither, delaying a tax refund, or even letting penalties and interest mount, in the vague hope some break will come your way.

Secondly, I'll repeat the old finance pro's admonition: Don't let the tax tail wag the investment dog. It would be easy for an investment mistake to wipe out any tax benefit that could come from an attempt to game the tax debate.

The heart of the president's plan is a proposal to eliminate the income tax investors now pay on dividends they receive from stocks. The White House estimates this could cut investors' taxes by $364 billion over 10 years.

Some investors are sure to switch money to stocks that pay high dividends, figuring these earnings will be tax-free. For ordinary investors, though, the amount at stake is small. (When I say stocks, I'm including mutual funds that own stocks.)

Among the 30 stocks that make up the Dow Jones industrial average, "dividend yield" is only 2.25 percent. So if you owned $100 worth of those stocks, you'd have received $2.25 in dividends in the past 12 months. Among the 500 stocks in the Standard & Poor's 500, the yield is only 1.72 percent, or $1.72 per $100 in holdings.

Let's say you sold some investments in order to buy $100,000 worth of stocks averaging a 2 percent yield -- paying $2,000 a year. If you are in the 30 percent tax bracket, you'd pay $600 in federal income tax on those dividends, leaving you with $1,400.

While it would be nice to save that $600, this is just over half of 1 percent of the value of your holdings -- a pittance. Your stocks could easily go down in price by that much in a single day, wiping out the tax savings.

The net tax benefit would be even smaller if you had to pay brokers' commissions to sell the old investments and buy the dividend-paying stocks. And the situation would be worse still if you had to pay a capital gains tax after selling the old investments at a profit.

What if you could find stocks that pay unusually large dividends?

Be sure to find out why the dividend yields are so high. Dividends paid over the past 12 months can look extremely generous if the stock price has fallen, which could mean the company is in trouble. What you make on dividends you could lose on a falling stock price, and troubled companies often cut or eliminate their dividend payments.

On a related issue, investors may be tempted to change their strategies with tax-deferred accounts such as 401(k)s. But this, too, could be a case of being too clever for your own good.

Under the current rules, dividend-paying stocks often do best in tax-deferred accounts such as 401(k)s. This way, the investor pays no annual income tax on dividends, as he must if the same investment were held in an ordinary taxable account.

Dividends that accumulate in the 401(k) or similar account are taxed as income when the investor makes withdrawals in retirement. But delaying the tax bill for years, perhaps decades, allows the tax-payment money to keep growing.

The president's plan could turn this around, making the taxable account the best place to keep dividend-paying stocks. Dividends in taxable accounts would be tax-free, while they'd continue to be taxed in the deferred accounts.

Does it make sense, then, to dump the dividend-payers in your deferred account and then buy them in your taxable account?

It might work, in theory. But, again, it's not likely that the sums involved would be big enough justify the commissions. And if you had to sell profitable investments in your taxable account to raise money to buy dividend payers, you might face a capital gains tax that would wipe out any other benefits.

Also, Congress might meet the president partway, giving only a partial dividend exemption -- and upsetting your calculations.

Yet another strategy involves betting that companies will raise their dividends if the president's proposal becomes law, since shareholders might clamor for tax-free income. But it's way too soon to bet on this possibility by loading up on stocks of companies that may, someday, pay more dividends -- if the rules change.

In fact, many companies may continue to shun dividends in favor of reinvesting profits to build business or buy back shares, as they do now. Under the president's plan, profits used this way could be tax-exempt for shareholders so long as the company had paid its fair share of taxes.

Shareholders would be allowed to add the value of these retained earnings to their original cost of acquiring the stock. This would reduce the investors' taxable profits when shares were sold, since profits are figured by subtracting original cost from sales proceeds.

Hence, investors might not press companies to raise dividends after all.

Bottom line: If you find a promising investment that pays big dividends, great. But if you make the hunt for dividends the heart of your investment strategy, your plans could blow up in your face.

Commenting has been disabled for this item.