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Don't Shun Dividends if Tax Rates Rise

Jeremy Glaser
Josh Peters, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Josh Peters. He's the editor of Morningstar DividendInvestor. We're going to look at some hot dividend topics.

Josh, thanks for talking with me today.

Josh Peters: Good to be here.

Glaser: So, let's start with the election. One of the things that we've been talking about for quite a while now is what's going to happen to the dividend tax rate, particularly in relation to the capital gains rate, after 2013. So, now that we know that the status quo, at least in terms of both houses of Congress and the White House is going to stay the same, do we have any more clarity on what's happening there?

Peters: Not a whole lot. If one political party or the other had swept the elections, I think then you could say things were a little bit clearer, but we have very much after $6 billion spent in this campaign returned the same group of people essentially more or less to Washington. It seems to be our form of revenge. This is how we get back at these politicians for making us watch all those horrible ads, is that we lock them up for kind of a cage match.

I think it's good to start with where we're at now, what's going to change on Jan. 1. Dividend income will again be taxed as ordinary income, and long-term capital gains, which right now is also taxed at 15%, like dividends are, will go to half of whatever your ordinary income tax rate. And then on top of that for high-income earners, already as a part of current law, there is another 3.8% tax to support the Affordable Care Act provisions. Of course, I can say Obamacare now right, because even the president calls it Obamacare. So, that tax increase is pretty much baked as they say.

The other two are still in flux, and I think that the most likely outcome is still what I saw a few months ago or even a year ago, which is that upper-income tax payers probably will wind up having to pay somewhat more, but that by the time all of the horse trading is done and we have a more comprehensive, more durable reform package, we should see dividends and capital gains still taxed at the same rate for everybody. Some people's marginal tax rate it might go from 15% to 20%, but I think for the most part, the idea of having it go to 39.6% I think most people understand that, that's not a real good idea at this point.

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Glaser: So, does this impact your thinking about if dividend stocks are attractive or if dividends in general are attractive, or is this really just a secondary consideration after the income stream?

Peters: It's really a secondary consideration, and I think the best way to phrase it is where are you going to go? If you have a portfolio right now in stocks that you're very happy with, say, it yields 4% and the dividend growth is coming through, raising your pay 5% or 6% a year--if you don't like the tax increase which is obviously going to cost you something, you don't have that many alternatives unfortunately. You could say go to bonds, but bonds yield less than this hypothetical portfolio of dividend-paying stocks does. Of course, we'd have a real set of model portfolios that yield more than 4% on average between them right now. So, it can be done.

If you go to bonds, say a 10-year Treasury, paying down in the 1.50% to 1.75% range and it's taxed as ordinary income, you could chase off into commodities. You could start trading the Japanese yen overnight. But I don't think that's how most people want to try to earn retirement income. And again short-term trading has always been taxed as ordinary income; that's not going to change.

I think where there might be a little bit of tension is that if there is difference between dividends and long-term capital gains, some investors might try and say, "Well, I want to get more growth because it's a lower tax rate." The problem is that if you're in retirement and you need that income, you can't count on the capital gains being there when you need it. It may very well turn out to be a capital loss instead. The consistency of the income that dividends can provide on a pretax basis, to me, will retain its value and its practicality even if the tax rate goes up.

Glaser: How about the firms themselves? We've heard from a few management teams that if the tax rates change, they may favor say share buybacks over dividend payments. Would you expect slower dividend growth because of say higher rates?

Peters: It depends on who you're looking at, and I think that's the one overwhelming piece of the backdrop that you don't want to ignore. And it's easy to ignore, when you are thinking day to day, week to week. But if you are thinking over the next five or 10 years, the demand for income is permanently shifting into high gear. As the baby boomers retire, they have to change their portfolios from being dividend-agnostic, maybe even preferring capital gains or speculation. They have to go for income; that's what they are going to need in order to meet their financial obligations and financial requirements. As that happens companies have to meet that demand, or they're going to be left behind. Some people wonder why is it that utilities stocks now trade at 14, 15, 16 times earnings and with big tech firms you'll find stocks trading at 10 times. Well, that's because investors now put the premium on the income. They don't put the premium on the growth anymore. And by the way big tech isn't growing like it used to either.

Now I'm not going to say that that justifies paying just any price for dividend, but the companies that aren't paying dividends now are going to have to eventually realize that that's something that they need to do in order to keep their investors. In the short term how this plays out is that companies that maybe don't want to pay the dividends anyway will use it as an excuse to divert funds elsewhere. But if I'm looking at the Southern Company, if I'm looking at General Mills, if I'm looking at American Electric Power, these companies are not going to change their dividend policies. They pay dividends when tax rates were very high, much higher than they are today. They've paid dividends for in some cases 100 years or more. I wouldn't expect any dramatic changes there.

It's something that shareholders will have to live with perhaps if worse comes to worse. But remember, too, that people have options. REITs aren't going to be affected by this directly, because the dividends are taxed as ordinary income, not as qualified dividends in the first place. Master limited partnerships, the same thing, and there you have potentially the tax deferral that is associated with the returns of capital for tax purposes in the distribution. If you have IRAs, if you have 401(k), if you have any kind of tax-deferred account, dividend tax doesn't affect you at all. So, there is a lot of different ways to manage through this without simply throwing up your hands and saying, "Well I'm done with these dividend payers because my tax has gone up."

Glaser: Josh, thanks for talking with me today.

Peters: Happy to be here.

Glaser: For Morningstar, I'm Jeremy Glaser.