Before the end of this year Congress has to make a decision
about how dividends are taxed. If Congress lets current law expire,
the current maximum 15% tax rate on qualified dividends will vanish
and dividends will revert to being taxed at ordinary income tax
rates. Right now that's 35%, but current individual income tax
rates also expire at the end of 2012; we won't know until the lame
duck session in Congress what rates will look like in 2013.
So it stands to reason that if dividend stocks are suddenly
taxed at a higher rate, their allure will fall, sending the value
of the stocks down. That wouldn't exactly be great news for
dividend stalwarts such as General Mills (
GIS
), Exxon-Mobil (
XOM
) and Coca-Cola (
KO
), right?
GIS Dividend
data by
YCharts
Not so fast, says James Morrow, manager of the $8.5 billion
Fidelity Equity Income fund. He and a few Fidelity colleagues who
traffic in dividend payers took a
deep dive
into the topic and emerged with the opinion that a boost in the tax
rate will not sink dividend stocks.
"Higher taxes are never good-but in my view, the possibility
that rates will increase doesn't alter the fundamental case for
dividend-paying stocks.," wrote Morrow.
According to the money managers, the fact that more than
one-third of U.S. stocks are held in tax-advantaged accounts such
as IRAs and 401(k)s, mitigates the impact of any change in tax law;
as long as your dividends are taxed into those tax-deferred
accounts you don't have to worry about the tax rate. Moreover, the
money managers note that most of the dividend income earned in the
U.S. goes to the 1%, and, well, they are so stinking rich, their
dividend income is less than 5% of their total income. So though
they may gripe a bit at a higher dividend tax rate, its impact is
likely not much more than a rounding error in their annual net
worth.
Morrow also pointed out an interesting counter-argument: a
change in the dividend tax rate could be part of a more
comprehensive tax bill that could address the taxation of how U.S.
corporations are taxed for earnings overseas. Right now, the likes
of Cisco (
CSCO
) and Apple (
AAPL
) keep boatloads of their earnings overseas rather than bring 'em
back and pay a tax rate as high as 35%. If that rate was reduced-to
get more of that money back to work in the U.S. economy -- the
theory is that the cash rich companies would turn around and boost
their dividend payouts. (Note: U.S. corporations can't use cash
held outside the country to pay out dividends.)
For the other 99%, though, it's important to understand the more
fundamental risk for dividend stocks. Namely, no matter how high
the yield, and no matter how healthy the payout ratio, dividend
payers are not immune to market drops.
Here's how a few popular dividend stocks performed during the
brunt of the financial-crisis sell-off, compared to the performance
of the Vanguard Growth ETF (
VUG
). You got a relative victory, wrapped in absolute losses as seen
in this
stock chart
.
KO
data by
YCharts
'
The SPDR S&P Dividend ETF (
SDY
), comprised of high yielders that have a long history of
maintaining or growing their dividend -- think Walgreen's (
WAG
), Sysco (
SYY
) and Consolidated Edison (
ED
) -- wasn't exactly a lifesaver when markets sank in 2011.
SDY
data by
YCharts
That's not a knock against dividend stocks. Just a reminder for
frustrated bond investors considering a shift into dividend stocks,
given the higher yields, that they will be buying a whole lot more
volatility.
Over the longer-term, that move can pay off. The total return
(yield plus price change) of the dividend ETF has handily beaten
the benchmark S&P 500.
SDY Total Return Price
data by
YCharts
Just beware that any intermittent market volatility could tax
your nerves.
Carla Fried is an editor for the
YCharts Pro Investor Service
which includes professional
stock charts
,
stock ratings
and
portfolio strategies
.