Tax Change Makes Dividend Paying Securities More Attractive
(NUI) – Many investors are taking a new look at stocks that pay dividends, as well as mutual funds that invest in dividend-paying stocks, since Congress passed the 2003 Tax Act. Dividend-paying investments have always provided benefits and may be even more appealing in light of the lower taxes on dividends.
Prior to the 2003 Tax Act, dividends from stocks and stock mutual funds were taxed at ordinary income tax rates. The highest income tax bracket prior to the legislation was 38.6 percent and currently is 35 percent. Now, investors pay taxes on qualified dividends at the long-term capital gain rate of either 5 percent or 15 percent, depending upon the income tax bracket.
In addition, corporate accounting scandals and the bursting of the technology bubble have given investors an appreciation for the relative solidity of companies that pay dividends. Returns on traditional sources of yield, such as money market funds, have essentially dried up as interest rates have fallen to 45-year lows.
This new appreciation for dividends has spawned a renewed interest in mutual funds that pay dividends, like the American Century Equity Income Fund, or TWEIX, which has been investing in dividend-paying stocks for nearly a decade.
“While the Tax Act doesn’t change how we manage our fund, it could give us a bigger pond to fish in,” said Equity Income co-portfolio manager Phil Davidson.
Companies have more of an incentive to start paying dividends or increasing payouts, boosting
returns for fund investors. In the past, some companies were reluctant to raise dividends because they believed investors cared more about capital appreciation due to lower taxation of capital gains, according to American Century’s Davidson.
“The stocks that benefit will be the ones with the strongest financial positions. The biggest long-term potential positive is improved capital discipline, which could lead to higher returns on capital and stock valuations,” said Davidson.
Investors tend to view companies that pay dividends as generally healthy. When companies pay dividends, they indicate that they can afford to share profits. Dividends represent tangible profits because companies are paying them in cash directly to stockholders.
Many types of stock mutual funds pass along qualified dividends to investors. But keep in mind that bond and money market mutual funds pay interest that is not considered a qualified dividend. Some mutual funds may pay a mix of interest and dividends. Any income that a mutual fund pays that is not from a qualified dividend will be taxed at the ordinary income tax rates. Investment return and fund share value will fluctuate, and if the individual stocks purchased by the fund do not continue dividend payments, the value of the fund shares may decline, even if stock prices are generally rising.