With the arrival of the fiscal cliff — the end of tax cuts established in 2001 and 2003 — just a few months away, it makes sense that a lot of investors are considering the way they approach certain stocks, in particular, those that pay healthy dividends.
The current tax rules put the maximum tax rate on qualified dividends at 15 percent. But assuming no action by Congress and the administration, the tax treatment of dividends will change dramatically. Dividends will be taxed as ordinary income, which would double the rate for taxpayers in the highest brackets.
The uncertainty is whether investors who are deeply committed to dividend-paying stocks will dump them in favor of a portfolio more weighted toward growth rather than income.
“Tax increases on dividends would not necessarily translate into a serious decline in share prices, and may, ironically, offer a buying opportunity for the dedicated long-term investor," according to a report from Federated Investors called "Has the Dividend Story Been Played Out?”
"The companies that are the highest payers are also, quite often, the strongest, most stable companies in the market, the ones that show the most fiscal restraint, and offer more than just dividends to entice shareholders.”
Microsoft, one of the first technology companies to initiate a dividend in January 2003, announced Tuesday it is raising its quarterly payout to 23 cents a share from 20 cents. The first dividend paid by Microsoft was 8 cents and has risen gradually over the past nine years.
Microsoft is a good example of why investors have flocked to dividend-paying companies. At its current price, the yield on the investment is nearly 3 percent, well above the rate on deposit accounts and money market funds. And with the Federal Reserve suggesting recently that short-term rates will remain low through at least mid-2015, the higher return from dividends is a welcomed relief for some investors who are willing to accept the risks of owning stocks.
Dividend-paying stocks, especially from companies that have a tradition of raising distributions on an annual basis, also provide a major portion of the long-term return of equities.
A report by Ned Davis Research finds that dividend-paying stocks in the S&P 500 Stock Index have posted an annualized total return of 8.7 percent between 1972 and 2012. The stocks in the S&P 500 that do not pay a dividend have appreciated at an annual rate of just 1.5 percent in the same period.
Dividends can also shine light on the financial strength of a company.
“Dividends enhance the earnings transparency of a company and exert a certain level of financial discipline on management," according to a white paper on dividends from RidgeWorth Investments. "They also increase corporate accountability and can be a signal of management's confidence for future growth prospects. At a time when corporate mishandlings seem to be the norm, a company's ability to pay steady and appreciating dividends over time provides tangible evidence of its financial stability and well-being.”
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