Not enough has been said about the new dividend tax law and how large an effect it can have for an investor -- even a modest investor. In the past, dividends were taxed at your rate of income, which for much of America meant a tax bite of about 25% to above 30%. Under the new law (until at least 2009, but likely to be extended), dividend income is taxed at only 15% for the four most common tax brackets -- yes, only 15%. Few forms of income are taxed at such a low rate.
Successful investing is about what you keep, rather than just what you make, and the dividend tax break makes it much easier for investors to beat the market where it counts: after taxes. Long-term capital gains tax rates have also fallen, from 20% to 15%, but to lock in that "benefit" you need to sell a stock. Investors in great companies at good prices rarely want to sell, so that leaves the dividend tax break as the most immediate and perhaps most relevant new tax benefit staring investors in the face.
You're not excited? We at the Fool are. In the last week, my colleagues Mathew Emmert and Tom Jacobs both wrote about the benefits of dividends. Mathew pointed out that since 1970, dividend-paying stocks have returned 1.4% monthly compared to just 0.9% for non-paying companies. A 0.5% monthly difference adds up.
Tom told us that over the last 75 years, dividends provided 40% of the S&P 500's total return. Plus, the stocks of dividend payers were much less volatile than non-payers. Additionally, some decades dividends provided the only return in the stock market. With the likes of Warren Buffett suggesting that stocks might only rise 6% to 8% annually the next decade, dividends may be integral to strong returns today more than ever. That you only throw 15% of your dividend income to the tax hounds greatly sweetens the deal.
Still not convinced? Let's roll out an example. Assume you own (for simplicity) 1,000 shares of Coca-Cola (NYSE:KO), which currently pays $0.88 per share in annual dividends, or 1.8% (the S&P 500 average). Coca-Cola religiously increases its dividend annually by double-digits, so we'll assume 11% annualized dividend growth from 2004 through 2009. Here, with 1,000 shares, is your dividend income.
Year Div. Payment2003 $0.88 $8802004 0.97 9702005 1.08 1,0802006 1.20 1,2002007 1.34 1,3402008 1.48 1,4802009 1.65 1,650 ------ $8,600
Over the course of the investment, you'd receive $8,600 in dividends, equaling 18% of your initial $47,000 investment in Coke. Assume you're in the 28% tax bracket. Under old tax laws, you'd pay $2,408 in dividend tax, or 28% of the dividend income. At the new 15% tax rate, you'll pay just $1,290 in taxes -- almost half as much.
Now consider the tax difference on an annual basis and assume you reinvest your dividends, earning 11% annualized gains on the money. Using the same dividend numbers from above, here's your net gain under the lower tax rate.
Tax Due atYear 28% 15% Diff. 2009 Value2003 $246 $132 $114 $2192004 271 145 126 2172005 302 162 140 2162006 336 180 156 2162007 375 201 174 2162008 414 221 193 2142009 462 247 215 215 ----- -----Total net gains $1,118 $1,513
Thanks to the 15% tax rate, you save $1,118 initially, which reinvested soon becomes worth more than $1,500 and counting. Over 10 more years, that $1,500 growing at 11% becomes $4,500 -- significant money that the government has basically given you. And this is from just a single dividend-paying stock -- one with a lowish 1.8% yield.
Meanwhile, the Coca-Cola dividend should keep rising each year until by 2009 the annual dividend yield on an investment made today should top 3.5%. (Because we assume the dividend grows to about $1.65 per share by then, and we assume you bought the stock at $47 today.) We've previously written about how dividend yields grow annually at strong companies; it's another beautiful thing about dividends that receives far less coverage than merited.
So, do you want to earn and keep more from your investments? Mathew Emmert has provided six stocks -- including ConAgraFoods (NYSE:CAG) and BellSouth (NYSE:BLS) -- with high yields and growth potential, and Tom Jacobs has provided three others with strong yields and growing businesses (because we don't like to buy for yield alone when we can buy companies that are paying dividends and increasing their share price).
Another big name to consider: SBC Communications (NYSE:SBC), the second-largest local phone company, pays a 4.4% yield and trades at 10 times earnings.
My favorite dividend-paying stocks include those I own: Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), PepsiCo (NYSE:PEP), Coca-Cola, Mellon Financial (NYSE:MEL), and Paychex (NASDAQ:PAYX). These companies all offer free dividend reinvestment plans (Drips), too. Couple free purchases with mere 15% tax payments on dividends, and you're earning more and keeping more. In fact, you're that much closer to beating the market.
Jeff Fischer couples dividend-paying stocks with high-growth stocks in his portfolio . For the new issue of our Hidden Gems newsletter, coming out today, Jeff features a stock he believes will double in price. The Fool has a disclosure policy .
