Taxation of dividends is only one of the many looming changes if the “fiscal cliff” is not resolved and various tax rules lapse. It is helpful to take a step back and revisit the purpose of dividends purpose and their tax treatment over the years.
The pending changes affect dividends from common stocks and from mutual funds that own common stocks. The income from most other investments (interest from bonds and bond mutual funds, most real estate investment trusts, energy partnerships, etc.) is taxed at the same rate as regular income. Capital gains, the difference between the purchase and sale prices of an investment, are taxed under separate rules.
Dividends are distributions of company earnings to owners of company stock. Company earnings can be used at the discretion of the board of directors to make dividend payments, to make investments in staff and facilities to grow the business, to make acquisitions, to buy stock back from stock owners or to accumulate cash for future use. Companies that may have lesser growth prospects, such as utilities, typically pay higher dividends than companies that have greater need for investment and opportunities for growth, such as technology companies.
Investopedia, an online financial dictionary, uses Microsoft as an example of the progression of the relationship between dividends and growth. As a high-flying growth company, it paid no dividends, but reinvested all earnings to fuel further growth. Eventually, Microsoft reached a point where it could no longer grow at the unprecedented rate it had maintained for so long. So, instead of rewarding shareholders through growth in its share price, the company began to use dividends as a way of keeping investors interested. The plan was announced in July 2004, nearly 18 years after the company’s stock debuted. The cash distribution plan put nearly $75 billion worth of value into the pockets of investors through a new 32 cent annual dividend, a special $3 one-time dividend, and a 30 billion share buyback program spanning four years. Microsoft now pays a 92 cent annual dividend for a dividend yield of 3.5%.
Stock dividends have generally grown steadily, which is one of the principal attractions of investing in stocks. Since 1960, the total amount of dividends paid by all the companies in the Standard & Poor’s 500 increased by an annual average of 4.92%. The decade of the ’80’s had the largest increase, while the period from 2000 to 2009 had the smallest increase. Dividends grew more than 15% in 1977, 1979 and 2005 and there were only seven years of dividend decreases. The largest drop was over 20% in 2009 as the financial crisis slashed dividends of financial companies nearly across the board. On average, companies paid out around 45% of their earnings in dividends, although that payout has been lower over the last decade and is now under 30%. Companies have been criticized for hoarding their cash rather than paying dividends or making business investments.
Another way to look at dividends is dividend yield, or the annual dividends paid divided by the prices of the companies’ stock. The dividend yield offers a way to compare stocks to other investments; since stocks have the potential to decline significantly, they are considered riskier than bank deposits or bonds and so have to offer investors greater potential return for that greater risk, and dividends are a considerable part of that return. On the other hand, if income from other investments is low, investors are willing to accept a lower dividend yield from stocks.
Since 1960, the average dividend yield on the S&P 500 has been around 3.13% and has ranged from 5.57% in 1981 (a period of high interest rates, so investors demanded higher yields from stocks) to 1.14% in 1999 (the height of the tech boom when stock prices were high and companies were offering high potential growth rather than dividends). Other data show a longer term (from 1880 to 2012) average dividend yield of 4.45% and a high of 13.8% in 1932 after stock prices had collapsed. Based on the last quarterly dividend reports in September, 2012 the dividend yield of the S&P 500 is currently 2.1%, quite attractive given today’s extremely low interest rates.
Since 2003, most common stock dividends were defined as “qualified dividends” by the IRS and were taxed at the lower long-term capital gains tax rates rather than as ordinary income as in the past. From 2003 to 2007, this meant that qualified dividends were taxed at only 5% for the lowest two tax brackets and at 15% for all other tax brackets. That 15% maximum rate was the lowest since 1941. From 2008 to 2012 it got even better, as qualified dividends were taxed at 0% for the lowest two brackets and a maximum 15% for all others. These lower rates were scheduled to expire in 2010 but were extended two years by President Obama. (This is not the only time dividends have received favorable treatment. Prior to 1987, taxpayers could exclude up to $200 in dividend income from taxable income. Corporations have long been able to exclude 70% of dividends from investments in other companies’ stock.)
If no deal is reached in Washington, all dividends will be taxed the same as ordinary income, at brackets ranging from 15% (the 10% bracket goes away) to the new highest bracket of 39.6%. And for wealthy taxpayers earning over $250,000 ($200,000 for single filers) there will be an additional 3.8% Medicare surtax on all investment income over the limit, including dividends.
Some investors have been selling dividend-oriented investments to avoid the possibility of higher taxes. This is probably a short-sighted overreaction, as the higher taxes are not certain and any other income will be taxed at least at the same rates as dividend income(except for the Medicare tax). At the same time, some corporations are accelerating dividend payments to take place in 2012 rather than in early 2013, just in case. Costco has gone so far as to make a $7 billion special dividend payment this year, even borrowing nearly half that amount because the dividend far exceeds its available cash. Costco stock rose nearly 10% after the dividend announcement as investors rushed to own the stock in time to receive the dividend.
Until dividends are taxed at higher rates than other income for all investors, they still represent a fundamental and attractive part of long-term stock investing. There will be plenty of hand-wringing about the potential changes in dividend taxation, but those changes should be kept in the context of other tax changes and overall economic growth.