The Error-Proof Portfolio: Don't Overdo Dividend Payers for Your Taxable Account

I know, I know, there's a lot to like about dividend-paying stocks. Although specific estimates vary by data source, dividends have composed a significant share of the S&P's total return during very long time frames. And even though dividends may not contribute such a big share of stock returns in the future, the ability to pay a dividend says a lot about a company's financial wherewithal. Roughly one third of the dividend-paying stocks in Morningstar's database earn financial health grades of B or better, versus just 14% of nondividend payers. Dividend payers, on average, also earn higher Morningstar Ratings for stocks and higher moat ratings than nondividend payers.

Many dividend bulls would also add the currently favorable tax treatment of dividend income to the list of what's right with dividend payers. Owing to the extension of the Bush-era tax cuts, qualified dividend income is currently taxed at just 15% for those in the 25% tax bracket and above, and those in the 10% and 15% tax brackets won't owe any taxes at all on qualified dividends. Because of that, you frequently see dividend-paying stocks and funds on lists of investments that make good sense for taxable accounts, right alongside tried-and-true tax-friendly investments such as municipal bonds, exchange-traded funds, index funds, and tax-managed funds.

That said, I think it's a mistake to get too carried away with adding dividend-paying stocks to your taxable portfolio. Here's why.

Control Issues
Even under the currently benign dividend-tax regime, dividend payers are less attractive for your taxable account than companies that do not pay dividends. The key reason is loss of control. If a company that you hold in your taxable account pays a dividend, that's a taxable event for you, whether you wanted that dividend or not. (If you hold a dividend-paying fund, you'll owe taxes on any dividends paid out, even if you've reinvested those dividends back into the fund.) By holding nondividend payers in your taxable accounts, by contrast, you won't be on the hook for taxes unless you take action and sell shares. Of course, you might decide that dividend payers' fundamental attractions supersede the tax considerations, but all else equal, dividend payers are less tax-efficient than nondividend payers, even in the current low-tax environment.

Current Tax Treatment Subject to Change
In addition, it's worth noting that the currently favorable tax treatment for dividends is only in effect for this year and next. In 2013, the tax on dividend income is set to revert to pre-2003 levels, meaning that dividend income will again be taxed at investors' ordinary income tax rates. If that happens, you may decide you want to get those dividend payers into a tax-sheltered wrapper like an IRA or 401(k) post-haste. After all, it's better to let those dividends compound rather than letting than IRS take a big cut right off the top. But if you need to trade out of dividend payers at that time, and the securities have appreciated since you originally bought them, you'll owe capital gains on that appreciation. In essence, improving your portfolio's tax efficiency for the future could force you to take a tax hit. Of course, it's possible that Congress could keep dividend tax rates on par with capital gains rates in 2013 and beyond. But it's worth bearing in mind that tax treatment of dividends may not remain as good as it is right now.

Not Everything Qualifies
The final reason to be careful about holding dividend payers in your taxable accounts is that not everything with a dividend yield qualifies for the currently low dividend tax treatment. While REIT dividend yields may be lush relative to the income you receive from other stocks, for example, those dividends are nonqualified, meaning that you'll owe ordinary income tax on that income. (Owing to that tax treatment, investors in the typical real estate fund have paid a tax-cost ratio of 1.9% per year during the past decade, far higher than any other equity category.) Foreign-stock dividends will not necessarily qualify for the low tax treatment, either. Unless a foreign-stock dividend counts as qualified, which usually means that the company is eligible for benefits under a U.S. tax treaty or trades as an ADR, you'll owe ordinary income tax on any dividends received.

Now, if you're in the habit of buying and holding individual stocks, you can do your homework and downplay some of those less-tax-friendly investments. But if you own mutual funds focused on dividend payers--such as those with "Equity Income" or "Dividend" in their names--you won't have the same opportunity to pick and choose. Unless a dividend-focused fund is explicitly tax-managed, the manager's only goal is to maximize income and total return. That means it's highly possible--even likely--the fund will hold companies that kick off nonqualified dividends, and such a fund may even own some bonds, to boot. (The typical equity-income fund owns about 6% in bonds, the income from which is taxed at investors' ordinary income tax rates.)

Bottom Line
None of this is to suggest that dividend-paying stocks should be verboten for your taxable accounts. You may decide, even after considering the potential tax pitfalls, to hold certain dividend payers in a taxable account because you like their fundamentals. Scrupulous attention to tax management--and paying attention to future tax rates--can also help reduce the drag of taxes on your portfolio of dividend payers. Just be careful to know what you own and to understand that dividend payers' currently favorable tax treatment may not stay that way.

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