Tax law: new appeal for old companies

Historically, 40 percent of the total return from stocks has resulted not from rising share prices but rather from dividend payouts.

Marvin Appel, PhD, and Brian Hufford, CPA

Historically, 40 percent of the total return from stocks has resulted not from rising share prices but rather from dividend payouts. This historical observation suggests that the recent federal tax cuts offer potentially valuable relief to investors.

Dividend taxation in a nutshell

For many years, dividend income was taxed at the highest possible income tax rate — that which applies to ordinary income. In contrast, profits realized from the sale of assets held for more than a year have received a more favorable long-term capital gains rate. Under the most recent tax brackets, the top federal rate on capital gains or dividends is only 15 percent, while the top rate on ordinary income is 35 percent.

The new tax law reduced the tax rate on dividends down to the capital gains rate. This means a lot to investors who hold dividend-paying stocks. For example, if the tax on dividends had not been reduced, $100 in taxable dividend income would shrink to $65 after federal taxes. But under the more favorable treatment, $100 in taxable dividend income results in $85 of income after federal taxes.

For dividend income to be taxed at the lower rates, you must hold the shares for 60 days, inclusive of the record date. (Investors who own shares on the record date get the entire dividend payment for that period.) You should note that none of these tax considerations applies to tax-deferred retirement accounts.

Why is this change good for individual investors?

One of the fundamental investment challenges faced by retirees is how to derive an increasing flow of income to keep up with rising prices. Tax-deferred retirement accounts and Social Security provide excellent solutions, but the benefits of these programs are limited by government regulations and may be insufficient to satisfy your own savings plan. Over the long term, both overall stock prices and dividend payouts have climbed, so investing in high-yielding stocks offers another approach you can use to generate a potentially rising income stream after you have contributed the maximum amount allowed to tax-deferred retirement accounts.

Risks

Of course, bondholders are guaranteed (short of credit default) to get their principal back, while shareholders are not. Also, stock prices have been much more volatile (risky) overall than bond prices. Because stocks have the potential to lose significant value, we do not recommend committing excessive capital to this or to any other buy-and-hold stock market strategy unless you can bear the risks involved.

An individual company may reduce or eliminate its dividend in hard times. Because the risk from any one company is significant, it is important that investors seeking dividend income to meet living expenses diversify their holdings among many dividend-paying stocks.

Exchange-traded funds with high dividend payouts

One simple way to avoid the pitfalls of major dividend reductions is to invest in exchange-traded funds (ETFs). ETFs hold baskets of stocks intended to track the price behavior of important market indexes. As a result, many ETFs are inherently diversified but require only one transaction on your part.

Moreover, the analysts who decide which stocks to include in their indexes generally try to weed out unstable companies. Their judgment is not infallible (witness Enron), but on the whole has been safer than simply picking the stocks that pay the most dividends. Another advantage of ETFs is their generally low expense ratios, which allow you to keep more of your dividend income than do most mutual funds.

Examples of diversified ETFs with above-average dividend yields (as reported in the Barron's issue of September 8, 2003) include:

• Diamonds (ticker DIA, yield 2.1 percent; an index fund that tracks the well known Dow Jones Industrial Average that is an index of 30 major U.S. corporations selected to represent a cross-section of the economy)

• The Dow Jones U.S. Large Cap Value Fund (ticker ELV, yield 2.4 percent; holds stocks in approximately 100 large U.S. companies whose shares appear undervalued)

• Dow Jones U.S. Small Cap Value Fund (ticker DSV, yield 3.1 percent; holds stocks in approximately 300 small U.S. companies whose shares appear undervalued)

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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