Cash in Hand
Heed the Yield Signs
Yield -- whether it comes from dividends or interest -- is a useful way to compare income-paying investments. But all yields are not equal, especially when taxes take their toll. Which types of investments will lead you down the best income path?
By Jeffrey R. Kosnett, Senior Editor, Kiplinger's Personal Finance
November 7, 2005
We're hard-wired to compare income-paying investments by their yields -- that is, the annual interest or dividend expressed as a percentage of the investment's market value. Yield is as useful a way as any to evaluate dissimilar assets such as certificates of deposit and Treasury bonds, or money-market mutual funds and real estate investment trusts (REITs). Generally speaking, if you commit money for additional years or take extra risk by investing in a volatile area such as oil, you should get a higher yield.
However, I find some investors (and even financial planners) forget to go beyond asking how much income to examining what kind of income. All 5% yields are not the same and may not even be better than a 4% yield from elsewhere. The key: taxes. Some investments pay interest, and others pay dividends, which are taxed differently. There's tax-exempt interest income from municipal bonds. There's also "return of capital," which is what it sounds like: The company is returning part of its stockholders' original investment. You don't owe current taxes on returns of capital, but if you sell your stock for a profit later, your stake (known as "basis") in the investment is cut. You end up reporting a larger capital gain. So it's really tax-deferred income.
These tax distinctions didn't matter much a year ago, when bank deposits paid less than 2% and REITs and oil and gas royalty trusts offered close to double-digit yields. The gap was so wide you couldn't go wrong even if you took a tax nip. But now that cautious stuff like CDs and money-market funds yield almost the same as some REITs and are closing in on oil and gas royalty trusts, a refresher is in order. Here goes:
Taxes
As a general rule, dividends are more tax-friendly than interest, unless all the earnings are inside an IRA or other tax-sheltered retirement plan. Starting in 2002, the government cut the top income-tax rate on dividends to 15%. Most interest is ordinary income and taxed just like your salary. The rate tops out at 35%.
This difference gives rise to some interesting contrasts. Verizon, the phone company, pays stockholders an annual dividend of $1.62 per share. The shares trade for $30, for a yield of 5.4%. Verizon also issues plenty of bonds. Depending on the term, the yield can be lower or higher than the stock, but often, it's lower. For example, a 10-year Verizon bond is priced to yield 5.1%, or 5.4% if you hold it to maturity in 2015. After taxes, the stock really shines as opposed to the bond (unless Congress kills the 15% rate, which is scheduled to expire in 2008). The stock also trades at its lowest price in five years, so the risk of buying it and suffering further sharp losses is not great. The stock is a good buy.
Most people refer to REITs' income payments as dividends, but the payments do not usually qualify for the 15% tax rate. That's because a REIT is not a corporation, and it doesn't pay taxes on its own earnings as long as it passes on 90% of its net income to its investors. But sometimes REITs do pay out partial income that qualifies for the 15% rate. That usually occurs after a REIT sells some property at a gain (never happens in real estate, right?) At last report, nearly 40% of REIT income qualified for 15%. This figure varies from place to place.
Advantage: Dividends.
Predictability
Most interest is fixed and guaranteed, provided the bank or the bond issuer doesn't go broke. Buy a bond and you know the size of the quarterly or semi-annual income payment. The same holds with CDs. The mystery is the new rate you'll find when a bond matures or a CD comes due. Kiplinger's thinks interest rates will go higher before they crest and turn down, so if you need to reinvest in a year or so, you'll do fine. It's when interest rates are high but falling fast that you can have your bond redeemed early and lose the right to that high income. So bond income is not always predictable. But for now, it is.
By contrast, dividends are subject to cuts, interruptions or freezes. Because corporate America is rich in cash and knows stockholders are getting a tax break, you've seen some fat dividend hikes lately. For example, Wells Fargo has doubled its annual dividend per share since 2001, from $1 to $2. Yet Wells Fargo is so healthy that it actually trimmed the percentage of profits it pays as dividends during this time. But with corporate earnings growth soon to slow in general, the chance for dividend freezes or cuts is building. If a company's dividend rests on the value of a commodity such as oil or natural gas whose price is falling, watch out. San Juan Basin Royalty Trust, which owns gas reserves in the Southwest, sells for $40 a share and pays close to a $3 annual dividend based on its last 12 monthly distributions. But its most recent monthly payout of 20 cents is down from 28 cents in July, so the trend looks negative. If the distribution keeps going down, so will the value of San Juan shares.
Advantage: Interest.
Simplicity
Dividends come in all kinds of flavors. For example, some of that San Juan royalty income is fully taxable, but a portion of it gets a break because of the complicated formula for gas-drilling tax deductions. Interest, however, comes in two kinds, taxable and tax-exempt. Interest is pretty basic. Generally, the Feds can't tax municipal bond interest, and the states cannot take a cut of Treasury bond interest. Payments from corporate bonds and bank accounts are taxed as regular income.
Advantage: Interest.
Final word
Interest wins on simplicity and predictability, but remember this: Dividends reflect the underlying prosperity of businesses and the economy. So do interest rates -- when the economy is strong, they tend to go up as well.
But when dividends rise, you come out ahead: Stocks usually go up when there's more cash for you and me.
When interest rates head higher, though, most bond prices fall. You don't come out ahead.
Right now, all things being equal, if you need to reach for yield, go to high-paying CDs or short-term bond funds for interest, and good quality stocks for dividends. It's a close call, but I declare the competition between interest and dividends to be a draw.
