Dividend Seekers, Don’t Fear Rising Taxes

Income Investing

Dividend Seekers, Don’t Fear Rising Taxes

Higher tax rates are no cause to give up on dividend stocks or funds that focus on them.

America’s robust dividend culture will survive whatever -- and I repeat, whatever -- Washington’s political tribes decide to do about the taxation of investment income. You’ll still see regular quarterly checks and generous annual increases in the payments. Higher tax rates will have no lasting effect on the value of dividend-paying shares. So if you love dividends, take a deep breath, exhale and relax.

SEE ALSO: Our 2013 Investing Forecasts

I know that under the most extreme outcome, some Americans would face a federal marginal tax rate of 43.4% on qualified dividends, which as I write this are taxed at 15%. So let us applaud Disney, Leggett & Platt, Wal-Mart Stores and others that moved up to December the dividend payments originally scheduled for January, guaranteeing one final bite at the 15% rate. That was a fine gesture, although it cost the companies next to nothing to part with the cash a few weeks early.

Strangely, though, some in the media reported on these expedited dividends in mournful tones -- despite zero evidence that any of these firms plan to abolish or cut payouts in 2013, even if the top tax rate triples. Disney even raised its disbursement by 25% at the same time it advanced the payment date for its dividend. Kiplinger's thinks the 15% tax rate for dividends is on its way out but will not rise to parity with ordinary income-tax rates. Plan on the rate climbing to 20% -- or 23.8%, if you are subject to the Medicare surtax on investment income. That is no cause to give up on dividend stocks or funds that focus on them.

The longer-term issue is whether increasing dividend tax rates will discourage companies from making higher distributions or investors from buying yield-oriented stocks. On the second question, there is exhaustive evidence (presented by WisdomTree Research) that the answer is no. Investors remain loyal to high-yielding or dividend-growth stocks because generous payouts provide evidence of a secure, well-run enterprise. On top of that, high-yielding stocks almost always outpace other stock categories in the years following hikes in dividend tax rates -- including the last time it happened, in 1993.


As for companies' willingness to raise dividends despite higher taxes, there's a long list of tough-to-refute arguments. Start with the 117 firms that initiated or restored dividends in 2011 and 2012, despite clear indications that the 15% rate would be up for review. Here are some others:

The influence of tax-exempt investors. Pension funds, endowments, insurance companies, and IRA and 401(k) investors collect about 75% of all dividends. Personal tax rates are irrelevant to them. WisdomTree research director Jeremy Schwartz notes that huge institutions, such as Calpers, the California public-employee pension fund, are saying they will shop aggressively for discounted high-dividend stocks if a tax increase sparks an irrational selloff.

Bond refugees. Until interest rates rebound, bonds "cannot cut it" as a competitor to income stocks, says Mark Freeman, a fund manager and chief investment officer of the Westwood Group. If it appears that investors are starting to defect to bonds, Freeman thinks, cash-rich companies might boost dividends faster than otherwise to offset higher taxes.

Changes in techland. In years past, a technology company might fall under suspicion if it paid dividends instead of spending those billions on research and takeovers. But who can accuse Apple of not being innovative just because it started paying a dividend last summer? Or look at Cisco Systems. It recently hiked its dividend by 75%, and in early December its stock yielded 3.0%. Both Apple and Cisco knew of the impending tussle over tax rates but still decided that sharing more profits with investors was a righteous use of their resources.

Jeff Kosnett is a senior editor at Kiplinger’s Personal Finance.

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