Fiscal Cliff Isn't the Only Reason to Downplay Dividend Payers in Taxable Accounts

The current debate about the fiscal cliff has some investors wringing their hands over their dividend-paying stocks. The tax rate on dividends is currently ultra-low--15% for most investors and 0% for those in the 10% and 15% tax brackets--but those rates are set to jump back up to investors' ordinary income tax rates at year-end unless Congress agrees to extend them. Needless to say, the ushering in of higher tax rates would make dividend payers decidedly less attractive for taxable accounts than they are currently. And even investors who don't hold dividend payers inside their taxable accounts might be concerned that less favorable tax treatment could spark a sell-off in the shares of dividend-paying companies.

But even if the currently low rates are extended, I'd argue that investors would be wise to not go overboard with dividend payers in their taxable accounts. Yes, dividends have composed a significant share of the S&P 500 Index's total return during very long time frames, and the ability to pay a dividend says a lot about a company's financial wherewithal. Dividend payers will be attractive from a fundamental standpoint regardless of their tax rate, as Josh Peters argued in this video. But tax-aware investors need to handle them with care for the following reasons.

Control Issues Even under a low-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.

Tax Treatment Changes Could Create Capital Gains Headaches In addition, it's worth noting that even if Congress decides to keep dividend tax rates relatively low for the next few years, the tax on dividends is likely to remain a political football in the years ahead. Even if investors receive a reprieve on higher dividend tax rates for next year or even a series of years, the dividend tax rate could climb in the future. If they need to trade out of dividend payers at that time, and the securities have appreciated since they originally bought them, they'll owe capital gains on that appreciation.

Not Everything Qualifies The final reason to be careful about holding dividend payers in your taxable accounts is that even if the currently low dividend tax treatment is extended, there will likely remain a distinction between qualified and nonqualified dividends. That means that dividend-focused investors will still need to be selective about which types of dividend payers they hold where. Although REIT dividend yields might 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. 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.

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.

A version of this article appeared Feb. 7, 2011.