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Dividends: Are They Important to You?

During the past several years, the dividend yields and payout ratios for most corporations have fallen appreciably. (The dividend yield is the annual dollar amount of dividend, divided by the price of the stock. The dividend payout ratio is the percentage of the company’s earnings per share that are paid as dividends.) As an example, the dividend yield on the Standard & Poors 500 stocks is just over a paltry 1 percent. Furthermore, many companies do not pay any dividends. General Electric, for example, has about a 1 percent dividend yield.

By contrast, some companies have huge dividend yields. Philip Morris pays over 7 percent; many utilities also pay high dividends. Companies that have lower dividend payout ratios and seek greater capital appreciation are termed growth stocks; those having higher dividend payouts are termed value stocks.

Why the Decrease?

The low dividend yields and payout ratios for many companies can be explained by the favorable tax treatment afforded to long-term capital gains provided in the Taxpayer Relief Act of 1997. Long-term capital gains are defined as gains from the sale or exchange of a capital asset, including investment property such as stocks and bonds held for a period of longer than one year. The act reduced the tax rate on long-term capital gains to a maximum of 20 percent, whereas the maximum tax rate on ordinary income is 39.6 percent (nearly twice as much). Short-term capital gains (same definition as long-term except held for a year or less) are taxed as ordinary income.

Cash dividends have the disadvantage that they are taxed as ordinary income, and the tax must be paid in the year the dividends are received — even if you reinvest them through a dividend reinvestment plan. By contrast, long-term capital gains taxes are postponed until the stock is sold. For example, a person could postpone the sale of appreciated stock until he or she retires when an even lower tax rate on long-term gains may be applicable. Furthermore, if a person who owns stock that has increased in value dies, beneficiaries do not have to pay tax on that increase in value. The capital gains tax can be completely avoided.

Clearly, long-term capital gains can provide significant tax advantages over dividends in taxable accounts. However, this tax advantage disappears in tax-deferred accounts such as individual retirement accounts and 401(k) plans because all withdrawals are taxed as ordinary income (or, in the case of Roth IRAs, they are not subject to any tax).

Profit Strategies

As a consequence of the tax advantages of long-term capital gains vs. cash dividends in taxable accounts, many companies pay small dividends, if any. Instead of paying dividends, managers usually attempt to invest profits in ways that will increase earnings and thereby further increase the value of the company’s common stock. These investments may be capital expenditures (designed to increase productivity or reduce costs) or acquisitions of other companies. In addition, some companies repay debt or repurchase their own stock to increase its price.

If a person has funds invested in a tax-deferred account (so there is no tax advantage of long-term capital gains over dividends), the issue of capital gains vs. dividends comes down to a question of who can best invest the profits. Are corporate managers better suited to invest the profits or are the shareholders? Many people believe that shareholders are better suited. If profits are high, managers may find themselves awash with money and spend it unwisely. For example, if a company pays a premium to repurchase its stock, that may not be a sound investment. Similarly, if a company pays a premium to acquire stock in another company, that, too, may be an unsound investment.

Given the tax advantages of capital gains in taxable accounts, if you do not need dividend income, the best advice may be to invest in growth stocks or mutual funds that hold mostly growth stocks. For tax-deferred accounts, on the other hand, it is wise to consider value stocks (or mutual funds that hold mostly value stocks). During the 1990s, growth stocks were all the rage; during the 1980s, value stocks were highly popular. No one knows what lies ahead. Maintaining a mix of growth and value stocks is another way to diversify your portfolio and thereby help to minimize risk.

Visit www.quicken.com/investments/drips/dripinvestor/corner4 for additional information on dividends. The information contained in this article is for general use only. Your specific situation may raise additional or different issues. Therefore, this article should be relied upon only when coordinated with professional tax and financial advice.