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Dividends or Share Buybacks: A Taxing Dilemma

With potential tax hikes looming, companies may elect to substitute share buybacks for dividends in the future. 

Alex Bryan, 10/23/2012

While there's been a lot of talk about the looming "fiscal cliff," rarely does even a highly partisan political divide prevent politicians from cooperating at the last minute to find some sort of temporary solution. Sure, the resolution may neither be prudent nor long-term in scope, but most can logically predict that something will be done. With that said, regardless of how the cliff is resolved, we believe investors should care more about how we'll be paying for the spending that will be incurred. There is a good chance that tax hikes are right around the corner, and those will directly hit most investors' pocketbooks if enacted.

Tick, Tick, Tick ...
If Congress does not take any action, starting on Jan. 1, the government will tax all dividends at ordinary income rates instead of the preferential 15% treatment for qualified payouts. On top of that, as part of the Health Care and Recognition Act of 2010, investors whose income exceeds $200,000 or $250,000 for single and joint filers, respectively, will be subject to an additional 3.8% Medicare surtax on all dividends, interest income, and capital gains. This new tax will remain in effect even if Congress extends the Bush tax cuts.

As a result, the top dividend tax rate could increase to 43.4% from 15%. Taxes on long-term capital gains are also scheduled to rise for most investors to 20% from 15%. (This rate will decrease to 10% for investors in the 15% income tax bracket.) However, with the Medicare surtax, the top rate will increase to 23.8%.

While we can't predict the outcome of the election, there is a good chance that these tax hikes will remain in place for investors in the upper income tax brackets. The Medicare surtax almost certainly isn't going away. Rather than trying to determine whether the tax changes will take effect, a more relevant question may be how to be prepared if they do.

Choose Your Poison
The scheduled tax changes would create an imbalance between dividend and capital gains tax rates, potentially creating an opportunity for tax arbitrage. Because dividend tax rates would exceed capital gains tax rates for most investors, share-buyback programs become a more tax-efficient method for companies to distribute cash to their shareholders. Although it is unlikely that companies will cut their dividends to improve tax efficiency, this creates an incentive for them to increase their share-buyback programs in lieu of raising their dividends to distribute excess cash in the future.

Consequently, investors relying on dividend growth may be disappointed. Funds that target companies with a history of increasing their dividends, such as Vanguard Dividend Appreciation ETF VIG, may be left with a more concentrated portfolio in the future as fewer companies continue to raise their dividends. Similarly, heavyweight dividend funds, including iShares High Yield Equity HDV and Schwab U.S. Dividend Equity ETF SCHD, may not sustain their current dividend yields as dividend growth stagnates.

It is true that in the 1960s, when tax rates were much higher than they are today, companies paid out a higher percentage of their earnings in dividends. However, share repurchases were uncommon during that time. A firm that continues to increase its dividends will be worth less on an aftertax basis than it would be if it had retained the cash or used it to repurchase shares. Even if some companies do not alter their payout behavior to maximize aftertax value, investors looking for cash distributions may be better served by firms with healthy share-repurchase programs.

In a share repurchase, the issuer buys back its own shares in the open market, either with cash from its balance sheet or by raising debt, reducing the number of shares outstanding. Classic finance theory suggests that the act of repurchasing shares does not increase the value of a company's stock. Although there are fewer shares outstanding, the company also has less cash or more debt, which reduces the total value of the company's equity by an offsetting amount.

Alex Bryan is an ETF analyst with Morningstar.

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