Dividends' Appeal Will Endure

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Tax considerations are often top-of-mind, particularly now with so much fluidity in the tax system and the upcoming changes or potential changes at the end of this year. I'm here today with Josh Peters, editor of Morningstar DividendInvestor, to get an update on what's happening with tax laws and how it could impact dividend payers.

Josh, thanks for joining me.

Josh Peters: Good to be here even if it's my least favorite topic.

Glaser: I know we've talked about this before, but can you just give us a quick update on what's happening with tax rates? What the current law is? What could happen in 2013? What do you think is likely to happen in terms of changes Congress could make?

Peters: Well, right now nothing is really changing. They really don't have a will or a way in Washington to pass any serious legislative reforms right now. I think we're going to have to get through the election and have to have that verdict from the American people before we'll see the two parties in Washington actually start to come together, make some compromises, cooperate a little bit, and start to solve some of these problems.

Now, under the current law as opposed to the current policy, we're looking at significant tax increases. You can call them the expiration of tax cuts, but for anybody who is been paying taxes at lower rates, which is almost all of us over the last five to 10 years, it's going to feel like, smell like, and hurt like a tax increase. And I think that most of economists are correct in saying that this is going to have a negative impact on the economy and could even tip us back into recession.

Now, realistically, are we going to just fall off that fiscal cliff, are we going to see all of the spending cuts and all of the tax cuts expire here at the end of the year? I don't really think that's realistic. After the election, there'll be some settling of the dust. Nobody wants us to actually tip back into the recession if it's something that we can prevent through actual legislation. So, the question becomes what do we get? My guess is, we'll see either the vast majority of the tax cuts or perhaps all of them extended, maybe not for two years this time, as we did in 2008 and 2010. Maybe it’s only a year. Some people have floated the idea of only three months. They continue to hold Washington's feet to the fire about enacting really comprehensive tax reform, but I just don't think that it's at all realistic that we're going to see tax rates all of the sudden shoot up.

Within that whole package of tax cuts, the current tax treatment of dividends is pretty important. Having leveled the playing field between long-term capital gains and dividends back in 2003, I think really corrected a historic inequity. There is no reason why the tax code should favor capital gains over dividends. They both come from the same source, corporate earnings, which themselves have already been taxed at the corporate level. I think even Congress, even in Washington, they understand this now, especially given the demographic background, knowing that more and more people are going to be looking to and relying on dividends in retirement. I really don't think that once we get to a reform stage that we're going to go back to effectively the bad old days when dividends really were taxed at penalizing rates.

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Glaser: If I am a dividend investor, and I'm out of the market right now, should I be making any changes? Should I be thinking about my investments differently because of potential tax changes, or is it something that you'll just have to kind of take your lumps when they come?

Peters: I think it’s very close to the latter honestly. Again, it's hard to predict what's going to actually happen in terms of changes to the tax law. We'll see. I'm optimistic that for all of the drama that is engineered around these things that we'll actually come up with some sensible solutions that are not going to hit dividends disproportionately hard. But you have to think about the alternatives. Let's say the current tax treatment simply expires, and the top marginal tax rate on dividends goes back to 39.6%, and then in fact there is another 3.8 percentage points laid on that as a consequence of the health-care reform package. So, it's north of 40% now for a marginal tax rate on dividends where long-term capital gains would be down in the mid-23% range. What do you do? Do capital gains become more appealing? Well, they might be in terms of taxation, but you still can't count on them to be there when you need to pay bills.

For retirees, to plot a strategy involving stocks that is predicated on getting capital gains like clockwork, I think that can be just devastating to your portfolio. If the market falls another 50%, all of a sudden you have to sell off twice as many shares at really low prices, eat through your portfolio very quickly, just to pay the bills. I think people want and still need that reliable dividend income even if it's taxed at a higher rate.

Remember, second, that most people, most investors even are in that top marginal tax bracket. For most investors, you'd be looking at perhaps going from 15% to 25% or 15% to 28%. I'm not going to minimize that; that's still a big chunk of your income going to taxes that wouldn't be under current policy. But it's important to keep it in perspective. Unless you are actually in that top tax bracket you don’t have to be concerned at the same level as somebody who is in terms of changing their own financial plan.

Another [reason] is that for most investors, especially middle-class investors, most of the stocks they own are in their IRAs and 401(k) plans. The tax rate on dividends doesn't affect that at all. You only pay tax on those earnings when you make withdrawals from the account.

And then remember, too, what's the alternative? All of this has to take place in a relative context. We are being dealt a hand as investors from the marketplace and from places like Washington, institutions like the government. How do we best maximize the value of our portfolios? If you want income, if that's your priority, do 10-year Treasury bonds at a 1.5% [yield] suddenly become more attractive than dividend-paying stocks that might be yielding 4% or 5% just because now they pay the same tax rate on both, as opposed to right now bond interest, for taxable bonds anyway, being taxed as ordinary income and dividends getting a break?

The relative appeal may diminish just a little bit, but in absolute terms, you'd think you're still way, way ahead with your dividend payers even in a worst-case scenario. So, there are a lot more moving pieces to this than just dividend taxes going up. We'll see what happens, but by no means has the appeal of dividend investing ever been just about a tax break that was enacted back in 2003.

Glaser: Josh, thanks for the update.

Peters: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.