Higher taxes may not hammer dividend stocks

[November 19, 2012]  NEW YORK (AP) -- If Washington allows tax cuts to expire at the end of the year, taxes on dividends will nearly triple for the highest-paid Americans. That's led some experts to warn of a looming collapse for popular dividend-paying stocks. When Uncle Sam charges a higher tax on something, they reason, it drives people away.

But judging by the country's previous experience taxing dividends, that may not be how things play out.

"Historically, big changes in taxes just have no effect on dividend stocks," says James Morrow, a fund manager at Fidelity Investments. "And our view is that you should lean on history."

Recent studies have examined how companies in the Standard & Poor's 500 index have fared over the past half-century when taxes on dividends change. They found dividend-paying stocks performing in seemingly unpredictable ways.

Between 1990 and 1993, for example, when dividend taxes climbed to a maximum of 39.6 percent from a maximum of 28 percent, dividend-paying stocks outperformed the broader market.

"The 'fiscal cliff' will be a big deal for the stock market if it's not avoided," says Russ Koesterich, global chief investment strategist for BlackRock's iShares group. "But it's probably not such a big deal for many dividend-yielding stocks."

Tax increases and government spending cuts known collectively as the "fiscal cliff" are set to take effect Jan. 1 unless Congress and President Barack Obama reach a deal first.

Obama wants to keep the tax cuts in place, including the 15 percent dividend rate, for people making less than $200,000. Republicans want to keep the tax cuts for everyone, including the 15 percent dividend rate, but have not taken a hard line on the dividend rate publicly.

Dividend payments were taxed like everyday income, meaning taxed by increasing brackets, until 2003, when Congress passed sweeping tax cuts backed by President George W. Bush.

The 2003 cuts reduced the tax on most dividends to 15 percent.

If Obama and Congress can't make a deal, and perhaps even if they can, dividends will be taxed like everyday income again. And the top marginal income tax rate will climb back to 39.6 percent from 35 percent, where it has stood since 2003.

The country's top earners will be taxed an additional 3.8 percent on dividends to pay for the president's health care overhaul, meaning the wealthy will pay 43.4 percent on dividends -- almost triple the tax they pay today.

For millions of Americans, a dividend tax increase won't matter. Stocks in most individual retirement accounts and 401(k)s will be unaffected until years from now, when the account holders cash them in.

Fidelity Investments has estimated two years ago that a third of U.S. stocks are held in tax-deferred accounts IRAs and 401(k)s. Another 13 percent are held by foreigners, who don't pay U.S. dividend taxes.

It's tricky to make any historical comparisons because nothing like this has happened before. There has never been such a large increase on dividend taxes, partly because they have generally gone down.

The closest historical parallel is probably the early 1990s, says David McGonigle, a fund manager at Copeland Capital Management. The top income-tax rate rose from 28 percent to 31 percent in 1991, then climbed to 39.6 percent in 1993.

So did higher taxes prompt investors to ditch dividend stocks? Not at all. Between 1990 and 1993, dividend-paying stocks returned an average of 12 percent a year. The S&P 500 returned an average of 10.7 percent.

Armed with these studies, some investors are arguing that dividend-paying stocks, especially those backed by large, cash-rich companies, will remain a relatively safe bet if Congress and Obama can't make a deal.

Without an agreement, stocks of all kinds are likely to fall. Since voters returned Obama and a divided Congress to power Nov. 6, the Dow Jones industrial average has fallen 700 points, more than 5 percent.

But dividend-paying companies, typically cash-rich and dependably able to churn out profits, could hold up better than others, even as taxes on them climb.

A group at Fidelity Investments took another angle and looked at dividend-paying stocks in the year before and after Congress approved the Bush tax cuts in May 2003.

If lower tax rates made stocks more appealing, they figured companies that raised their dividends would see their stock prices surge.

It turned out that the most generous companies, the top fifth in terms of dividend yield, fared the worst over the two years, while stingy stocks did well. Companies weren't being rewarded for paying dividends, and they scaled back.

"After the Bush tax cuts you'd think, 'Hey, here comes a surge in dividends,'" says Morrow, the Fidelity fund manager. "What did we see? The exact opposite. Dividends are at an all-time low."

Companies in the S&P 500 paid 27 percent of earnings to investors in dividends last year, according to research from Goldman Sachs. Over the past 50 years, the payout ratio has rarely dropped below 40 percent.Â

If history is any guide, companies may decide to protect investors from higher taxes by rewarding them with higher dividends, according to a Goldman Sachs report.

In 1960, when Dwight D. Eisenhower was president, rich Americans paid a tax on dividends as high as 91 percent because that was the top marginal income tax rate. And companies were much more generous. They paid 64 percent of earnings in dividends.

Even assuming dividend taxes rise, dividend-paying stocks will still be an attractive alternative to some other investments.

For example, 10-year Treasurys yield about 1.6 percent. That's substantially below the average 2.6 percent yield of dividend-paying companies in the S&P 500. Both would be taxed as ordinary income.

Koesterich, from BlackRock, says companies have plenty of room to raise dividends to compensate investors for the bigger cut they're handing to Uncle Sam.

"They certainly have the ability," Koesterich says. "And they know a substantial portion of people are buying their stock because of the yield."

[Associated Press; By MATTHEW CRAFT]

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