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Why Taxes Won't Torpedo Dividend Stocks

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Never has there been more uncertainty about taxes than there is today. With taxes of all sorts and sizes slated to rise in less than four months, some investors seem to be on the verge of panic about how to respond to whatever the future may bring. But a more measured approach to adjusting your portfolio for possible tax hikes will serve you much better than just reflexively making major changes to your entire investment strategy.

Lots of taxes on the table
Without new legislation from Congress, a whole host of taxes could go up substantially at the beginning of 2011. Regular income tax rates for nearly everyone could go up as a result of the sunset provisions within the provisions of the 2001 tax cuts. Rates on capital gains, which have been held to a maximum of 15%, would rise to 20%. The estate tax, which has disappeared for 2010, will come back to hit households with a much-lower wealth threshold of just $1 million, down from $3.5 million last year.

Perhaps most troubling are the provisions that would affect the way dividend payments are taxed. Right now, investors who receive qualified dividends enjoy the same 15% maximum tax rate as capital gains. Without a renewal of that provision, though, ordinary income tax rates would apply in 2011 in beyond, potentially more than doubling that 15% rate.

That in turn has some financial experts looking at their recommendations on how to allocate portfolios across different types of stocks. With a focus on after-tax income, a big tax change can make some dividend stocks look less attractive than alternatives.

Revenge of the munis?
In particular, for conservative investors in high tax brackets, dividend stocks often compete with municipal bonds as a way to get the most take-home pay from your investments after taking care of the tax man. For instance, right now, 10-year municipal bonds pay an average of just under 2.5%, according to Bloomberg. Under the current tax rates, that's less than the after-tax yield on these dividend stocks:

Stock

Dividend Yield

After-Tax Yield at 15%

Procter & Gamble (NYSE: PG  )

3.2%

2.7%

Chevron (NYSE: CVX  )

3.6%

3.1%

McDonald's (NYSE: MCD  )

3.0%

2.6%

Kraft Foods (NYSE: KFT  )

3.7%

3.2%

Source: Yahoo! Finance as of Sept. 15.

However, things change substantially if dividend tax rates rise. For top-bracket taxpayers paying close to 40%, McDonald's has an after-tax yield of just 1.8%, while Kraft's payout falls to 2.2% -- below the current rate on muni bonds. That could lead some income-seeking investors to pull out of dividend stocks and into munis.

Why the sky isn't falling
Some conclude that despite the advantages of strong dividend stocks, a massive move by investors out of them could push their prices lower. Yet there are several reasons to believe that dividend stocks won't be as sensitive to tax-rate changes as many fear.

First, if you're like many people, you already hold dividend stocks in a tax-favored account like an IRA to shelter their income from taxation entirely. The tax deferral these accounts offer make it irrelevant to you what the current tax rates are -- all you care about is what they are when you withdraw money.

Second, many companies don't qualify for preferential treatment on their dividends, so their shareholders already pay ordinary rates on the income. Annaly Capital (NYSE: NLY  ) and American Capital (Nasdaq: AGNC  ) are among the many high-yielding REITs whose dividends don't qualify for the 15% maximum rate. Similarly, almost none of the 11% yield of Apollo Investment (Nasdaq: AINV  ) counts as a qualified dividend. Eliminating preferential treatment on dividend taxes won't affect those shareholders at all.

Don't panic
While it's always smart to take tax considerations into account with your investments, don't let tax uncertainty make you panic. Stick with a solid investment strategy, and it'll take you far toward reaching your financial goals.

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True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger's favorite torpedo scene is in The Hunt for Red October, which he's watched more times than he can count. He doesn't own shares of the companies mentioned in this article. Chevron and Procter & Gamble are Motley Fool Income Investor choices. The Fool owns shares of and has written covered calls on Procter & Gamble and owns shares of Annaly Capital Management. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy sunk my battleship!


Read/Post Comments (3) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 17, 2010, at 7:15 AM, Hal10034 wrote:

    If dividends are taxed as ordinary income, then yields will have to go up and stock prices down. The question is by how much. But Timothy Geithner wants Congress to raise the dividend tax rate only to 20%:

    http://www.nasdaq.com/aspx/stock-market-news-story.aspx?stor...

    I think this would have only a minimal effect, but someone who can crunch the numbers would know better than I do.

  • Report this Comment On September 17, 2010, at 12:38 PM, jbgoode33 wrote:

    If you're an investor in foreign shares, don't forget the dividend tax.

  • Report this Comment On September 22, 2010, at 10:17 AM, TheDumbMoney wrote:

    It blows my mind that Congress has ever or would ever thought/think it's a good idea to have capital gains taxed at a vastly lower rate than dividends. I get that it's about taxing the dividend "income" of "rich folks" like me (who drives a ten-year-old Volvo). But it just shifts where people put their money, and the real effects are to disincentivize the very best corporate behavior, and to encourage pure market speculation at the expense stock market investment. It is such bad public policy.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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