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Peters: What Higher Taxes Could Mean for Dividend Investors

Jeremy Glaser

Jeremy Glaser: For, I'm Jeremy Glaser. We are looking at taxes this week, and one big question a lot of investors have is about how their dividends are going to be taxed.

I am here today with Josh Peters to discuss dividends and taxation.

Josh, thanks for joining me.

Josh Peters: Good to be with you, Jeremy.

Glaser: So, let's talk a little bit about the best place to hold dividend-paying stocks. Obviously, you have your choice between your tax-advantaged accounts, like your IRAs or maybe just regular taxable brokerage account. Can you walk us through some of the decisions that investors need to make in deciding where to put these dividend stocks?

Peters: Well, I think it depends on where the dividends are going. If you are retired, then there is a pretty sizable advantage to maybe biasing your fixed-income holdings, where you pay full ordinary income tax rates, into your tax-deferred accounts, where the tax rate on dividends being lower isn't of any assistance. And then, try to own your dividend-paying stocks just in an ordinary taxable account, where you can benefit from that reduced 15% maximum federal rate on dividend income.

If, on other hand, you are somebody who is younger, you are still accumulating your savings, you want to reinvest your dividends, then I would try to herd as much money into your tax-deferred accounts as possible. That way you don't have to pay any taxes on the income that you are just going to reinvest anyway.

Glaser: So, you mentioned reinvesting dividends in your tax-deferred accounts, your tax-advantaged accounts. Is that something that you recommend for most people? Or would it make sense to maybe use that cash and deploy it into other securities or have other uses of that cash?

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Peters: Well, when I talk about dividend reinvestment, I am talking about just not taking the money and spending it on something else or moving it into a different asset class, let's say. There are two good ways of reinvesting dividends: one that you could call the passive, or automatic, path is to set up some kind of automatic plan with your broker or may even the company that issues the stock to have each dividend automatically reinvested back into the company that paid it.

That has the value of simplicity, but what I prefer instead is what I call a more active strategy, where I just take all of my dividends in cash and in two model portfolios that I manage for DividendInvestor. And once I get up to an amount that I figure is an efficient level to make a transaction, where my commission cost isn't going to be too high as a percentage of what I'm investing--I just pick out whatever I think my most attractive opportunity is at that point among the stocks I already hold, and I concentrate all the money in that position.

This is actually what I did in late December, the last trading day of the year. I had accumulated a fair amount of cash in both accounts, the Builder and the Harvest, and I bought more GE for the Builder. I thought it was the best opportunity at the time, still do honestly. And National Grid I bulked up on in the Harvest.

Glaser: So, it sounds like when deciding how you want to reinvest those dividends, it is really an investment decision you are making and not something that can be related to taxation.

Peters: The tax question is really about where you hold the money, what type of account, and the investment decision is what you are going to do with it once you want to reinvest those dividends.

Glaser: Maybe we could gaze into the crystal ball for a minute and talk a little bit about the future of dividend taxation. In 2013 currently, dividend tax rates are scheduled to go up. Can you talk a little bit about if you think that's going to happen and what the potential outcomes are for those changes in dividend tax rates?

Peters: Well, as you know, everything that is in place right now, not just even with dividends and capital gains, but with income tax rates and lots of other tax credits and deductions--all of these things are going to expire here at the end of this year. And we'd like, obviously, for Congress and the administration to get together to start working on some sort of overhaul of the tax code, something that hopefully would make it simpler.

One of the priorities, I think, that has to go into that is keeping the tax treatment of dividends and capital gains the same. As you know, historically, capital gains have typically gotten a break, sometimes a big discount from an investor's ordinary income tax rates, where dividends were taxed as ordinary income. What this spells for the end of 2012 and beginning of 2013 is that you could have a capital gains tax rates go from, say, 15% to about 20%, but the top marginal tax rate on dividends could go up from 15% all the way perhaps to 40% for somebody who is in the top tax bracket. So that is something that's going to get a lot of attention.

It's hard to know what is actually going to happen from a legislative standpoint. I mean, what we've seen in the past is that so many of these things just get renewed for another couple of years at a time. It sort of becomes the status quo as opposed to a temporary break.

One thing that I refer back to quite often is that both among Republicans and Democrats, I think, there's an understanding that you don't want to bias the tax code in favor of capital gains and against dividends. When President Obama was running as Candidate Obama back in 2008, his campaign plan did call for a higher tax rate, top tax rate, for investment income, but he wanted to keep the tax rates the same, and I think that's actually the most important point. We don't know where tax rates might go or where they might have to go given the fiscal situation for the country, but I think the No. 1 priority is, we don't want to see the tax code go back to biasing itself against dividend income.

Glaser: So, now, if the rates were to increase, is that another argument for holding those dividend-paying stocks in your tax-deferred accounts, or do you think it's really too speculative to be deciding based on what tax rates may do in a year or so?

Peters: Well, it's interesting to me how emotional this topic gets for some people, and I think emotions go into taxes all the time--it's a highly charged subject. When you start to pick the situation apart, for most people, even the worst-case outcome, what we'll call the worst-case outcome here, where the current tax code just expires and reverts back to what it was in 2000, that's not necessarily going to hit very many people. Most people don't pay the top marginal tax rate. Most people are not going to wind up paying a 40% tax rate on their dividend income. Most people have most of their money for retirement in tax-deferred accounts, where their marginal rate of taxation on dividends and capital gains literally doesn't matter. You only pay tax when you are making withdrawals.

My message to people is don't let yourself get caught up in the idea that dividend-paying stocks are attractive only because of the current tax treatment--meaning, if you think in terms of people's need for income going forward and what they have to choose from, well, dividends right now and capital gains are taxed the same, but Treasury bond interest or corporate bond interest is taxed at ordinary income. So, if dividends go back to being taxed at ordinary income again, well, guess what? You're not going to get yourself a tax break by, say, going off and deciding to own bonds, instead. You could, in theory, try to bias your portfolio more in favor of capital gains if there was a lower tax rate associated with it. But what do we learn again and again and again? Those capital gains just can't be relied on. You can't assume that the market is going to go up 5% or 10% or however many percentage points a year to automatically give you the increased assets, so that you can make withdrawals without having to deplete your portfolio.

So, to me, the real reason that you want to own dividend-paying stocks is getting that steady income, participating directly in the profits of the business, letting the market take care of itself over shorter time periods. A tax rate change, even the worst-case scenario--again, to refer back, I said just everything expiring--really doesn't change that value proposition that much for that many people.

Glaser: For boards of directors, would you expect if the tax rates were to change that we'd see even more of a bias towards share buybacks versus dividends as a way to return capital to shareholders, or do you think those discussions are made without respect to the tax treatment?

Peters: I think for some companies the tax treatment is important. A few years ago when the tax rate regime looked like it was going to expire again, there were a couple of companies that tried to hurry up and get dividends out the door before the tax rate might have gone up if new legislation hadn't passed; that happened in 2010.

For most companies, I think, where you've got well-established dividend policies--your Johnson & Johnsons, your Procter & Gambles have been paying dividends, good ones, for many, many years. They are not going to look at a change in the tax codes, and say, "Well now we're just going to ditch the dividend or we're going to stop growing it [and] we're going to put all of our resources behind share buybacks." I don't think you're going to see any kind of change like that.

In fact, we're continuing to see some pretty good dividend growth across the market. I don't think that the potential for a tax rate increase is hindering companies right now that much. In particular, I really enjoyed some news that we got from the CME Group, the parent of the Chicago Mercantile Exchange last week. They increased their dividend 59%, and then decided to institute an annual special dividend with the extra cash flow that they didn't need to reinvest in the business. They looked at share buybacks, but honestly the CFO on a conference call said that he thinks investors prefer this regular returns of dividends--the steadier, more reliable returns of dividends. They want to appeal on the basis of that, not on how many shares they are buying back. And let’s face it: We've had how many hundreds and hundreds of billions of dollars of shares repurchased over the last 10 years. The market is pretty much back where it started. [Buybacks are] just not really moving the needle like it should for investors.

That said, if we go forward from here and the tax code does go back to being biased against dividends, then the same companies that don't want to pay dividends right now, like an Apple or a Google perhaps, they are not going to want to pay the dividend going forward, and they're just going to use the tax code as an excuse, and I think that's the right word: excuse. It isn't that these companies couldn't pay or shouldn't pay, they just don't want to. And at some point I think they start to pay a price in the valuation of their stock and their appeal to individual shareholders in an era that is going to increasingly focus on income.

Glaser: Josh, thanks for your thoughts on taxes today.

Peters: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.