What Will Happen to the Dividend Tax Cut?

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. With the Bush tax cuts scheduled to expire at the end of 2010, many investors are wondering if dividend tax rates are going to go way up after they were cut in 2003. Here to discuss the different possibilities is the editor of Morningstar DividendInvestor, Josh Peters. Josh, thanks for talking with me today.

Josh Peters: Yeah, I just wish it was a happier topic.

Glaser: A question on a lot of people's minds is, are dividend tax rates going to go back to that highest marginal tax rate like they were beforehand?

Peters: Well, what is sitting on the law books right now, that is essentially what it is, that the top marginal tax rate for all income would go back to 39.6%; qualified dividends would cease to be in existence, essentially they would all be taxed as ordinary income, which means if you make enough money, 39.6% is what you would pay on your dividend income. Most tax payers actually pay far less, but you get the point.

And then long-term capital gains would go back to half of the old marginal tax rate. So a maximum of 19.6%. Those would both be up from 15% caps currently on both dividends and long term capital gains.

Glaser: Do you think this is the most likely outcome?

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Peters: No, I mean it's kind of hard once you get into politics. I mean the status quo is always a pretty good bet, but I don't think that anybody's going to perceive this as just the passing of a temporary benefit. I think when people see that they're paying higher taxes on their investment income, whether it is capital gains or dividends, they're going to perceive that as a tax increase.

And most people don't think this is a great time to look at increasing taxes when the economy is still weak, a lot of households are still under financial pressure. I think the best indication of what to expect is really what we saw in the President's budget where he proposes to make permanent the existing tax rates with an additional 20% bracket for household incomes above $250,000.

So you would still have the 5%, 10%, 15% brackets for qualified dividends and for long-term capital gains, you would have this additional 20% rate for what I suppose you would call the "rich," depending on how you want to define that.

But I think the most critical piece of that, that I'm most encouraged about is that you're continuing to tax capital gains and long-term capital gains and dividends at the same rate.

Glaser: Would you think that investors should begin thinking about moving out of dividend-paying stocks if the marginal tax rates is going to go way up or could go way up, or do you think that there are benefits that dividends give that make the tax treatment less important?

Peters: Well, it's amazing once you start to sift down the matter, you know how few people this will actually affect. If the President's proposal becomes law, and most people are still paying 10% or 15% on their dividend income, their taxes are not going to go up at all.

Now if you change the tax rate for some people, they're essentially earning a lower after-tax return. You are changing kind of the investment mix and risk and reward profile on an after-tax basis for certain segment of the market, and people might see dividend stocks as perhaps a little less attractive at the margin.

And there might be some people just saying, "Well taxes are going up, so I'm going to sell," without necessarily taking time to think through the math, see how it affects them personally.

But I will tell you, dividends didn't start to work for investors only in 2003 when the current tax treatment was brought about. Dividends have been working for investors and stocks for centuries.

Because this is what corporations are essentially formed to do, from a shareholder's point of view, take shareholder capital, employ it in a profitable business, and then return those profits to the people who supply the capital. Those are called dividends.

And in this country anyway where a lot of companies tend to be kind of stingy about dividends and would rather do other things with their cash flow, dividend-paying stocks tend to be more mature than the average company. They're kind of the grownups of corporate America.

They recognize that they can't grow necessarily at a double-digit rate forever, but they owe their shareholders a good return in cash. These are usually more stable businesses. They are usually more financially secure businesses. I think it provides the individual investor with a lot of advantages beyond just what your tax rate might happen to be.

Glaser: Sounds like there's no need to panic, but certainly something that people should keep their eyes on for the rest of the year?

Peters: Yeah. I'm definitely going to watch the legislative process and see what winds its way through Congress, but the way I look at it is you've got one party in Washington that does not want to raise any taxes and you've got another party in Washington that wouldn't want to raise any taxes if it would make them unpopular.

So, I'll let you decide which party is which in that model, but I think that there's a very good chance that at the very least we'll see dividends and capital gains continue to be taxed at the same rates. Why is that important? Because you don't want to provide a built-in bias in the tax code of one type of investment return over another, because that really starts to bias how corporations make capital allocation decisions and that doesn't necessarily serve shareholders well.

I mean look at the 1990s, an awful lot of money got thrown away because dividends were becoming less and less important and people used taxes as an excuse not to pay dividends or not to care about receiving dividends from an investor's point of view. That didn't work, let's get back to work what does work.

As long as the tax code treats them both the same, then I don't think that we're going to see any marginal problems associated even if the tax rates for some folks do go up.

Glaser: Josh, thanks for speaking with me today.

Peters: Thank you very much.

Glaser: For Morningstar.com, I'm Jeremy Glaser.