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The year 2010 is particularly exciting for those who breathlessly follow tax developments. Unless our government steps in, a slew of Bush-era tax cuts will expire at the end of the year. Thus, we may see a slew of special one-time dividends paid out by companies before the clock strikes midnight. But before you get too excited, remember that special dividends aren't all they appear to be.
Right now, the maximum 15% tax rate applies to most dividend income. As of Jan. 1, that rate is slated to revert to the ordinary income rate. It falls in the 25% to 28% range for most of us, but could be as high as 39.6% for wealthier folks. If you collect $10,000 per year in dividends, your tax hit will go from $1,500 to $2,500, or $2,800, or possibly to nearly $4,000.
If you depend on dividend income, don't panic. The Obama administration is talking about hiking the rate to only 20%. Still, even that will be a meaningful increase some people, which may explain why companies are considering paying special dividends while rates are lower.
In fact, many stocks have already paid or announced them:
- Weyerhaeuser (NYSE: WY ) recently announced that it will pay out $5.6 billion as a special dividend -- a whopping $26.47 per share, from a company that normally pays out $0.20 per year. This was in preparation for the company's conversion to a real estate investment trust (REIT), after which it will be required to pay out nearly all of its earnings as a dividend.
- Garmin (Nasdaq: GRMN ) is doubling its regular dividend this year, from $0.75 to $1.50, just for the year.
- Hot Topic announced a $1 special dividend this year, though its regular annual dividend is just $0.28.
- Transocean (NYSE: RIG ) declared a $1 billion special dividend in February, before the Gulf oil spill, and then caused a stir afterward by sticking to its plans.
Not a green flag
Special dividends don't necessarily bode well for a company. Palm paid out $9 per share back in 2007 (getting the cash partly via debt and a private equity investment), and has since been gobbled up by Hewlett-Packard. TD AMERITRADE paid out a special $6 dividend in 2006, and its stock has steadily fallen since that time.
In another sense, special dividends are actually discouraging: If a company is able to pay out an unusually large chunk of cash to its shareholders, that often means it can't think of anything better to do with it. Also, if the company has significant insider ownership, the special dividend may be a way to help those insiders reward themselves.
Plenty of companies these days are sitting on a lot of cash. Some shareholders of Apple (Nasdaq: AAPL ) and other businesses have argued that these hoarders should pay that cash to shareholders if they can't do anything better with it. But others are content to leave the moola in these companies' vaults, so that they'll have the flexibility to act quickly and boldly if an opportunity arises. Berkshire Hathaway's (NYSE: BRK-B ) Warren Buffett is famous for holding onto big cash stakes in order to be ready for big acquisitions. I'm not going to second-guess a successful CEO like Buffett, nor suggest that he should pay me cash instead of hanging on to that money for a powerful purchase such as that railroad Berkshire recently bought.
When "special" really isn't
Finally, while management may want to signal confidence and strength via a special dividend, it could do so much more convincingly with an increase in the regular dividend. That would suggest that the company feels comfortable in its ability to meet the bigger annual obligation. Some companies, such as Diamond Offshore Drilling (NYSE: DO ) , have combined regular dividends with special ones year after year. That's an interesting compromise; it gives shareholders a payout they can roughly count on, plus the likelihood of more.
Some dividend yields are outrageous in a bad way.