Planning with dividends after the 2003 act

By Seth Hammer, CPA, Ph.D.
Towson University

The Jobs and Growth Tax Relief Reconciliation Act of 2003 provides new tax advantages for income generated from qualifying dividends.

Under the act, taxpayers are subject to tax rates of 15 percent or 5 percent (or 0 percent for certain taxpayers in 2008) for qualifying dividend income received through the year 2008. While welcoming the rate reductions, however, taxpayers and their advisers may have concerns about how to best configure an investment portfolio to achieve optimal after-tax performance. These concerns may include the potential consequences of strategies that:

use "conservative" equities, such as utilities or preferred stock, as alternatives to fully taxable bond investments; and / or

reconfigure equity portfolios to contain a larger proportion of value stocks, versus growth stocks, in order to increase current tax-advantaged income.

For some investors, an additional concern in following the act may be the role of real estate investment trusts (REITs). Distributions from such investments generally do not qualify for reduced tax rates but may provide opportunities for partially tax-free distributions.

'Conservative' equity investments as bond alternatives

Investors who would like to take advantage of the reduced rates for dividends might consider using utility stocks as an alternative to bonds for the more conservative portion of their portfolio.

For many years, utilities had been referred to as "widows' and orphans'" investments because they were deemed to provide low volatility and consistent returns for individuals who could not afford to assume very much risk. Following deregulation, however, utilities have become increasingly risky investments. For example, Constellation Energy Group, owner of Baltimore Gas and Electric, had the following total returns (per Morningstar) for the last five years:

1999: zero
2000: plus 63 percent
2001: minus 40 percent
2002: plus 9 percent
2003: plus 45 percent

Another potential alternative to bonds that offers reduced tax rates is qualifying preferred stocks. Here, taxpayers should be able to achieve a significant reduction in risk, as compared to the risk associated with common stocks. Nonetheless, holders of preferred stock should keep in mind that the probability of receiving a current payout can be significantly less than that for holders of bonds. Bondholders can demand current interest payments. But with the threat of corporate liquidation, preferred shareholders' only leverage, generally, is that they must be paid before common shareholders can receive any common dividend payments.

A second important concern is that preferred stocks, unlike bonds, do not have maturity dates for redemption, increasing the risk of being subject to below-market returns for extended periods of time. Another possible detriment of investing in preferred stocks is that these investments are largely traded among institutional investors, potentially making purchases or sales of individual issues costly and / or difficult.

Value vs. growth stocks

A recent study suggests that future earnings growth will be higher for companies that have higher payout ratios than for companies that have lower payout ratios (study by R. Arnott and C. Asness in Financial Analysts Journal, January / February 2003). Such findings contradict the views of individuals who believe reinvestment (rather than distributions of earnings) will lead to higher growth.

Nonetheless, investors may wish to consider historical performance over the last 10 years before making a substantive reapportionment of their equities portfolio. During each of the last four years, large-value stocks provided a better total return than large-growth stocks. However, for each of the six years prior to that, growth stocks provided a superior total return than value stocks.

Further, since average dividend payments for all stocks typically average less than 2 percent per year, and since the bulk of the total return is likely to be achieved by capital appreciation (subject to the same tax-advantaged rates applicable to dividends), many investors may find that any potential tax benefits achieved by creating an imbalance between the two categories of stock will be outweighed by the potential investment risk associated with an unbalance portfolio.

REITs as a supplement or alternative

Investments in real estate investment trusts (REITs) may merit consideration in situations in which there is a desire for both current income and capital appreciation. REITs normally provide significantly higher dividends than common-stock investments while offering much greater opportunities for capital appreciation than preferred stock.

Dividends from REITs normally do not qualify for reduced rates but often contain a nontaxable element, usually arising from property depreciation. Opportunities for proportionately higher non-taxable distributions have potentially increased, following enactment of an act provision that allows 50 percent bonus depreciation for qualifying leasehold improvements.

A final factor that may prove pivotal in investors' decisions whether to begin investing or to increase holdings in REITs is that their correlation with bond performance has been very low (e.g., less than 20 percent during the 1980s and 1990s), providing excellent opportunities for portfolio diversification.

Contact this Author: < Seth Hammer > shammer@towson.edu

This content has not yet been Rated.

To Rate content, please Login.