How to Play the Dividend Cut

You may want to rethink the securities you hold

If they're going to wipe out the tax on dividends, you load up on stocks with fat payouts, right? Not necessarily. Figuring out how to make President Bush's tax-cut initiative work for you will take more thought than that. The plan may focus on dividends, but it could affect your entire financial profile--from asset allocation to which accounts hold what securities.

So what should you do now? Probably nothing, until the plan gets ironed out in Congress. A lot can change before a tax cut passes, even in a Republican-controlled legislature. Moreover, taxes should be just one consideration when investing--not the main focus.

Asset allocation is always the primary concern. How much should be in stocks, bonds, cash, and other investments, given your financial position, age, and appetite for risk? On that count, the initiative doesn't call for big changes.

Even so, you may need to tinker with the types of stocks and bonds you buy. Scrapping the dividend tax benefits stocks of large, mature corporations that pay out more dividends than small companies, which need to retain cash to grow. Gregory R. Friedman, chief investment officer of Greycourt & Co., an investment consulting firm in Pittsburgh, reckons that with no tax on dividends, the large caps' returns will be nearly equal that of small caps'. Given the added risk of smaller companies, their appeal will be diminished.

At the outset, eliminating the tax on dividends will make it attractive to own value stocks in low-growth businesses such as electric, gas, and telephone utilities. You'll also have to look not just at companies that pay good dividends but at those with the cash flow to start paying them. "Growth companies will make payouts if investors demand it," says Donald J. Peters, portfolio manager of the T. Rowe Price Tax-Efficient Balanced Fund (PRTEX ). Part of Bush's proposal would allow shareholders to deduct some money from their capital-gains taxes for earnings that aren't paid out as dividends. The savings won't be as great, but enough to make it worth holding on to a rapidly growing company.

In the bond arena, municipal bonds will suffer the most. "If you have another asset class offering tax-free income, munis won't have as much of an advantage," says Daniel C. Dektar, chief investment officer at Smith Breeden Associates Inc. True, the average stock in the Standard & Poor's 500-stock index pays a paltry 1.8% dividend yield, vs. a 3.7% yield on a 10-year top-grade muni. But stocks also offer the potential for capital appreciation and dividend increases, which bonds don't when held to maturity.

Munis could also get competition from preferred stocks. These securities, because they pay fixed dividends (now ranging from 5% to 8%), are less volatile than stocks and behave more like bonds. Preferreds are just a tiny market now, but if dividends become tax free, companies will rush to issue them.

Besides thinking about what stocks and bonds you own, you have to question where you own them. Your retirement account will be at a disadvantage if it holds dividend payers. The IRS will tax that dividend money as ordinary income when you eventually withdraw it. "Owning a dividend stock in a retirement account will be just like owning a muni bond in one," says Ed Slott, editor of a retirement newsletter. "You get none of the advantages of the tax cut."

For older investors--say, 50 and up--the best bet may be to hold all your dividend stocks outside the tax-deferred account, and leave that to otherwise taxable bonds. If you're younger, that may not be the optimal strategy. With a long time horizon, you might expect to earn far more in capital gains than from dividends, so holding stock in a tax-deferred account still makes sense.

You'll be a big beneficiary if you're a buy-and-hold sort--someone who trades little, thereby incurring little in taxable gains, and just collects dividends. Sounds kind of dull? But if the President has its way, that's the kind of behavior that will be rewarded.

By Lewis Braham, with Susan Scherreik and Carol Marie Cropper, in New York

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