Dividends Rise, Tax Hikes May Follow

U.S. shareholders are seeing companies boost dividends again, after two years of sharp declines in payouts. However, at the same time, taxes on their dividends could be heading higher, taking a bite out of shareholders' income and potentially hurting the performance of dividend-paying stocks.

So far in 2010, 10 companies in the large-cap Standard & Poor's 500-stock index that hadn't been paying dividends started doing so, according to Standard & Poor's. Another 146 increased their quarterly payout. Just one company—Valero Energy (VLO)—has lowered its dividend, and another, refiner Tesoro (TSO), canceled it altogether.

Taxes on these dividends could be rising because, at the end of 2010, tax cuts implemented under former President George W. Bush automatically expire. The federal tax on dividends is now capped at 15 percent but, unless Congress extends the Bush cuts, the highest rate could jump to 39.6 percent.

The short-term effect of a higher dividend tax could be significant, particularly for stocks with generous payouts. "The higher the yield, the more negative impact there could be," says Henry Sanders, portfolio manager of the Aston/River Road Dividend All Cap Value Fund (ARDEX).

Dividends can be an important source of an investor's total return. According to Standard & Poor's, dividends have contributed 45 percent of the total return of the S&P 500 since 1928.

Over the long term, "dividend-paying stocks tend to outperform non-dividend-paying stocks and tend to do so with less risk," Sanders says. Their appeal is enhanced at a time when other investments, like bonds, are providing historically low yields. "Right now people are desperate for income," Sanders says.

Dividend Raisers

In July, Walgreen (WAG) hiked its dividend 27.3 percent, General Electric's (GE) dividend rose 20 percent, and manufacturer Cummins (CMI) hiked its dividend 50 percent. Starbucks (SBUX) raised its dividend 30 percent in July, just one quarter after paying the company's first dividend ever. Founder and Chief Executive Officer Howard Schultz told analysts July 21 the increase was a sign "the board has confidence in the financial performance of the company and the amount of cash that we generate."

"We've had companies bump up their dividends as management teams gain confidence in the outlook," says John Buckingham, chief investment officer at Al Frank Asset Management.

Expect the dividend increases to continue. Bloomberg analysts use criteria such as options, company guidance, and industry analysis to forecast dividends. In the third quarter of 2010, which ends Sept. 30, another 20 companies in the S&P 500 are forecasted to increase dividends. Analysts estimate the three largest increases of the rest of the quarter will come from: Pioneer Natural Resources (PXD), with an estimated 50 percent increase; News Corp. (NWSA), with an estimated 20 percent increase; and Microsoft (MSFT), with an estimated 15.4 percent hike.

Just one company, Frontier Communications (FTR), was forecasted by Bloomberg analysts to reduce its payout this quarter, a move already announced as part of an $8.6 billion acquisition of 4.8 million rural phone lines from Verizon (VZ), completed on July 1.

Despite the increases, dividends remain far below pre-recession levels. According to Standard & Poor's, the S&P 500 has boosted payouts a net $12.4 billion year-to-date, but in 2008 and 2009, S&P 500 companies cut dividends by a net combined $58.8 billion.

"We've got a way to go here," Sanders says. He cites the example of GE, which despite its recent increase, still pays shareholders 61 percent less per quarter than it did in 2008 and early 2009.

Tax Threat

Another factor weighing on dividend-paying stocks is the threat of higher taxes. A maximum rate of 39.6 percent on dividend income would bring taxes back to the level set in 1993 under President Bill Clinton, when dividends were taxed the same as ordinary income.

President Obama has proposed capping dividend taxes at 20 percent, but many investors are waiting to see what deal, if any, emerges from Congress.

Financial adviser Mark Rylance, of R.S. Crum in Newport Beach, Calif., says taxes will be a factor in how many dividend-paying stocks end up in client portfolios. However, he finds it "impossible" to predict what politicians eventually decide to do. After all, he says, Congress could even decide to extend the Bush tax cuts through 2011. "We're trying to not make decisions [based] on speculation," Rylance says.

The stock market impact "depends on the extent of the tax hike," says Standard & Poor's equity analyst Tom Graves. Though Graves expects a 20 percent tax rate to have minimal impact on the stock market, a higher rate could hurt the performance of stocks and exchange-traded funds that pay out larger dividend yields, he says.

A tax increase could help shareholders in one way over the near term: If companies get the news that dividend taxes are headed higher, they may choose to pay out large, one-time "special dividends" before the end of the year so they're taxed at a lower rate, said Bank of America Merrill Lynch chief U.S. equity strategist David Bianco in a July 23 note.

Overblown Issue?

Others think the tax issue is being overblown. Because investors suspect dividend taxes are headed higher, "the market has already priced it in," Buckingham says. In fact, he says, when Congress sets 2011 taxes and uncertainty clears up, dividend stocks could rally as a result—even if taxes are higher.

Christian Thwaites, president and chief executive officer of Sentinel Investments, calls the dividend tax issue a "non-story" for investors. He points out that the higher tax would be irrelevant for shareholders using tax-protected accounts like 401(k)s and individual retirement accounts, as well as for pension funds, annuities, trusts, foreign investors, and companies and institutions that own stock. Furthermore, a 39.6 percent tax rate—the worst-case scenario—would only apply to individuals in the very highest tax bracket. "Most people are not going to be paying anywhere near the 40 percent tax rate," Thwaites says.

The tax issue should do nothing to dent the appeal of dividend-paying stocks, Thwaites says. "We're in a period now where a good healthy dividend policy is something investors are looking for."

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