The Uncertain Yield of Untaxed Dividends
Depressed by the three-year slide in equities? Wondering if it's time to give up on the stock investments in your retirement savings account? Uncertain about where to invest your hard-earned money? If so, the confusion is only going to get worse, thanks to President Bush's proposal making the repeal of the tax that investors pay on dividends the centerpiece of his $670 billion, 10-year tax cut.
The long-term impact on personal financial planning will be dramatic if double taxation of dividends is eliminated. Money held in taxable accounts could flow toward mutual funds designed to pay out high dividends and minimize capital gains. Savers in for the long haul likely would shift their asset-allocation strategies, stuffing tax-advantaged 401(k)s, 403(b)s, and comparable retirement savings with bonds while keeping their equity investments in taxable accounts.
OUT OF FAVOR? Savvy savers will shun popular tax-sheltered investments like variable annuities -- essentially a mutual fund wrapped in a tax-deferred insurance-firm account. "If there are no taxes on dividends, that's a huge argument against any kind of tax-shelter shell," says Ross Levin, a certified financial planner and president of Accredited Investors. Adds Jeremy Siegel, finance professor at the Wharton School and author of the '90s investment bible, Stocks for the Long Run: "Anything that is designed to defer taxes will be hit."
The Bush dividend plan is controversial. Democrats are assailing it as a massive giveaway to the rich. Many policymakers worry about a mushrooming budget deficit. Some economists, like Siegel, are dismayed by the Administration's approach. By all means, says Siegel, get rid of double taxation -- but do so in a different manner: Allow companies to deduct dividends as they do their interest payments. That change would do away with the current incentive for corporations to load up on debt. Investors would still pay taxes when they receive dividends or interest.
Given the Republicans' thin margin of power in Washington, Bush's proposal could still founder. "Investors shouldn't make any changes yet," advises Joel Dickson, tax specialist at the Vanguard Group. "We don't know what the final package will look like." But they should follow the debate closely. Meanwhile, in anticipation of some change to dividend taxation, investors are likely to take a shine to quality stocks that pay a dividend.
ALTERED PRIORITIES. A lot more companies could start shelling out dividends, considering that more than 65% of today's public outfits don't issue them, vs. less than 30% back in 1960. Indeed, dividend payouts shrank to an historic low during the go-go era of the '90s. Of the 18% average annual return measured by the Standard&Poor's 500-stock index in the '90s, dividends accounted for a mere 16%, according to Frank Felicelli, a certified financial analyst at Franklin Templeton Investments, Private Investment Group. Yet over the past 75 years, dividends contributed over 43% of the market's total return. Already, dividends declared by companies in the S&P 500 are increasing for the first time in two years.
Under the Bush proposal, both equity-index and actively managed mutual funds held in taxable accounts should attract more investor money. For one thing, equity mutual funds make two kinds of annual taxable distributions. Taxes are paid on capital-gains distributions from the realized net profit on securities sold after being held for more than a year. These gains are taxed at the maximum federal rate of 20% (10% for taxpayers in the 10% or 15% tax bracket).
But income distributions, which include dividends as well as net gains on the sale of investments held by the fund for less than a year, are taxed as ordinary income at the owner's highest marginal tax rate. Not only would the tax burden ease these current income distributions, but long-term investors likely would reinvest the dividend portion of their payout back into the fund free of tax.
CANADIAN LESSON. Even more striking, the mutual-fund industry can be expected to quickly come up with hundreds of funds explicitly designed to maximize dividend payouts and keep down capital-gains obligations. That has been the experience in Canada, where dividends are taxed far more lightly than ordinary income. "A whole cottage industry of dividend-paying mutual funds that limit capital gains has developed because of the beneficial treatment," says Moshe A. Milevsky, finance professor at the Schulich School of Business at York University in Toronto. Adds Milevsky: "In Canada, dividends are a way of life."
In sharp contrast, less money may flow to tax-deferred accounts. Take variable annuities. Despite their popularity, variable annuities are a high-cost product. Management and marketing fees for each mutual fund-like subaccount in a variable annuity run from 0.9% and more than 3% of assets a year, according to a recent study by Consumer Reports. Insurance charges average 1.3% but can reach as high as 1.85% annually. Worse, any long-term capital gains earned in a variable annuity are taxed upon withdrawal at the much higher ordinary-income rate.
Of course, changes in the tax code have nothing to do with evaluating risk. Investors will still have to decide on the best asset allocation. Is it 70% stocks and 30% bonds? Or is that too risky, making a 50/50 split between stocks and bonds preferable? Yet once an investor decides on an asset allocation, the proposed tax changes have implications for what accounts get what asset.
EVIDENCE TO BANK ON. The typical baby boomer in a 401(k) has a hefty chunk of money in the stock market -- and that may not make as much financial sense as before. For example, investors will still pay taxes on interest income. Why not park fixed-income securities in a 401(k) plan? Equity investments might do better in a taxable account. After all,if the President gets his way, dividend payments will be exempt from taxes. And instead of withdrawals during retirement being taxed at the ordinary-income rate, which can run as high as 38.6%, long-term savers could cash in their gains at the much lower capital-gains rate.
A change in the way dividends are treated has much to commend it, not least the fact that these payouts are a check on corporate malfeasance. Indeed, before audited returns became the norm, dividends were management's way of proving that company profits were real rather than cooked. "Management can't pay cash to shareholders unless the cash actually is earned," notes Edward Yardeni, chief investment strategist at Prudential Securities. Adds York University's Milevsky: "I like the notion of not having double taxation. It appeals to my sense of fairness."
Rank-and-file economists have long advocated eliminating the double taxation of dividends, as have a number of Administrations, including those of Ford and Carter. This time around, and assuming it becomes law, it will take months to sort out all the investment implications of the dividend proposal. Stay tuned
The long-term impact on personal financial planning will be dramatic if double taxation of dividends is eliminated. Money held in taxable accounts could flow toward mutual funds designed to pay out high dividends and minimize capital gains. Savers in for the long haul likely would shift their asset-allocation strategies, stuffing tax-advantaged 401(k)s, 403(b)s, and comparable retirement savings with bonds while keeping their equity investments in taxable accounts.
OUT OF FAVOR? Savvy savers will shun popular tax-sheltered investments like variable annuities -- essentially a mutual fund wrapped in a tax-deferred insurance-firm account. "If there are no taxes on dividends, that's a huge argument against any kind of tax-shelter shell," says Ross Levin, a certified financial planner and president of Accredited Investors. Adds Jeremy Siegel, finance professor at the Wharton School and author of the '90s investment bible, Stocks for the Long Run: "Anything that is designed to defer taxes will be hit."
The Bush dividend plan is controversial. Democrats are assailing it as a massive giveaway to the rich. Many policymakers worry about a mushrooming budget deficit. Some economists, like Siegel, are dismayed by the Administration's approach. By all means, says Siegel, get rid of double taxation -- but do so in a different manner: Allow companies to deduct dividends as they do their interest payments. That change would do away with the current incentive for corporations to load up on debt. Investors would still pay taxes when they receive dividends or interest.
Given the Republicans' thin margin of power in Washington, Bush's proposal could still founder. "Investors shouldn't make any changes yet," advises Joel Dickson, tax specialist at the Vanguard Group. "We don't know what the final package will look like." But they should follow the debate closely. Meanwhile, in anticipation of some change to dividend taxation, investors are likely to take a shine to quality stocks that pay a dividend.
ALTERED PRIORITIES. A lot more companies could start shelling out dividends, considering that more than 65% of today's public outfits don't issue them, vs. less than 30% back in 1960. Indeed, dividend payouts shrank to an historic low during the go-go era of the '90s. Of the 18% average annual return measured by the Standard&Poor's 500-stock index in the '90s, dividends accounted for a mere 16%, according to Frank Felicelli, a certified financial analyst at Franklin Templeton Investments, Private Investment Group. Yet over the past 75 years, dividends contributed over 43% of the market's total return. Already, dividends declared by companies in the S&P 500 are increasing for the first time in two years.
Under the Bush proposal, both equity-index and actively managed mutual funds held in taxable accounts should attract more investor money. For one thing, equity mutual funds make two kinds of annual taxable distributions. Taxes are paid on capital-gains distributions from the realized net profit on securities sold after being held for more than a year. These gains are taxed at the maximum federal rate of 20% (10% for taxpayers in the 10% or 15% tax bracket).
But income distributions, which include dividends as well as net gains on the sale of investments held by the fund for less than a year, are taxed as ordinary income at the owner's highest marginal tax rate. Not only would the tax burden ease these current income distributions, but long-term investors likely would reinvest the dividend portion of their payout back into the fund free of tax.
CANADIAN LESSON. Even more striking, the mutual-fund industry can be expected to quickly come up with hundreds of funds explicitly designed to maximize dividend payouts and keep down capital-gains obligations. That has been the experience in Canada, where dividends are taxed far more lightly than ordinary income. "A whole cottage industry of dividend-paying mutual funds that limit capital gains has developed because of the beneficial treatment," says Moshe A. Milevsky, finance professor at the Schulich School of Business at York University in Toronto. Adds Milevsky: "In Canada, dividends are a way of life."
In sharp contrast, less money may flow to tax-deferred accounts. Take variable annuities. Despite their popularity, variable annuities are a high-cost product. Management and marketing fees for each mutual fund-like subaccount in a variable annuity run from 0.9% and more than 3% of assets a year, according to a recent study by Consumer Reports. Insurance charges average 1.3% but can reach as high as 1.85% annually. Worse, any long-term capital gains earned in a variable annuity are taxed upon withdrawal at the much higher ordinary-income rate.
Of course, changes in the tax code have nothing to do with evaluating risk. Investors will still have to decide on the best asset allocation. Is it 70% stocks and 30% bonds? Or is that too risky, making a 50/50 split between stocks and bonds preferable? Yet once an investor decides on an asset allocation, the proposed tax changes have implications for what accounts get what asset.
EVIDENCE TO BANK ON. The typical baby boomer in a 401(k) has a hefty chunk of money in the stock market -- and that may not make as much financial sense as before. For example, investors will still pay taxes on interest income. Why not park fixed-income securities in a 401(k) plan? Equity investments might do better in a taxable account. After all,if the President gets his way, dividend payments will be exempt from taxes. And instead of withdrawals during retirement being taxed at the ordinary-income rate, which can run as high as 38.6%, long-term savers could cash in their gains at the much lower capital-gains rate.
A change in the way dividends are treated has much to commend it, not least the fact that these payouts are a check on corporate malfeasance. Indeed, before audited returns became the norm, dividends were management's way of proving that company profits were real rather than cooked. "Management can't pay cash to shareholders unless the cash actually is earned," notes Edward Yardeni, chief investment strategist at Prudential Securities. Adds York University's Milevsky: "I like the notion of not having double taxation. It appeals to my sense of fairness."
Rank-and-file economists have long advocated eliminating the double taxation of dividends, as have a number of Administrations, including those of Ford and Carter. This time around, and assuming it becomes law, it will take months to sort out all the investment implications of the dividend proposal. Stay tuned
