Preparing for higher dividend taxes

NEW YORK Thu Feb 23, 2012 5:47pm EST

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NEW YORK (Reuters) - A popular class of stocks could soon come with higher taxes.

President Barack Obama's budget plan released last week calls for taxing dividends at ordinary income levels for individuals making more than $200,000 a year and couples making more than $250,000. The plan, which returns the tax treatment of dividends back to policies in place before 2003, would raise an estimated $206.4 billion over 10 years.

The proposal comes at a time when investors are increasingly turning to dividends for steady returns. Despite low growth rates that have long resulted in low price to earnings multiples, high-dividend paying utility companies in the Standard & Poor's 500 index are trading at a premium to the broad stock market because of their steady payout rates.

Historically low bond yields are the main reason behind the new love for cash-rich companies that pay big dividends. Johnson & Johnson, for instance, offers a dividend yield of 3.5 percent. The 10-year U.S. Treasury, meanwhile, yields 2 percent.

Few budget proposals ever get enacted, especially in an election year. But some fund managers and financial advisers are already preparing for higher dividend taxes in the near future, given the size of the deficit and polls that show many Americans favor higher taxes for the rich.

Here are a few ways wealthy investors could prepare should the favorable tax treatment of dividends come to an end:

EXPECT VALUATIONS TO FALL

Higher taxes would most likely make companies that pay dividends cheaper, experts say.

"I think the effect about (which) we can be most certain is a decline in multiples," said Alan Auerbach, an economics professor at the University of California, Berkeley.

Auerbach studied the effects of the 2003 dividend tax cut and found that high-yielding companies were the biggest beneficiaries of the tax cut.

Mark Lamkin, founder of Louisville, Kentucky-based Lamkin Wealth Management, said companies such as Johnson & Johnson would lose the premium they received because of their dividend payments. He expects the company would lose $4 from its current share price of $65, or a 6 percent drop.

Historically, dividend-paying stocks have lagged companies that do not pay dividends for about six months after a dividend tax increase, according to Ned Davis Research Group. The worst of the underperformance comes in the first three months after the tax rise, the company noted. Companies that did not pay dividends gained 50 percent more than companies that did offer payouts during that time.

But analysts say that longer-term investors could benefit from the declines.

"If history is any guide, this will provide a buying opportunity for the dividend-oriented investor," said Linda Duessel, a senior equity strategist at Federated Investors who specializes in equity income.

She expects dividend-paying stocks to outperform their counterparts over the long term.

Don Wordell, a portfolio manager of the $2 billion RidgeWorth Mid Cap Value fund (SMVTX), said higher taxes on dividend income would not affect his long-term approach but could offer short-term benefits.

"Every stock that I own pays a dividend and we were doing this long before the tax laws changed," he said. But, he added: "If on the margin people sold because of this, it would be an excellent buying opportunity."

Wordell favors dividend-paying stocks because they tend to have proven business models and healthy balance sheets.

Investors willing to take the bet that share price declines are a buying opportunity should consider a dividend-focused fund or ETF. The SPDR S&P Dividend ETF (SDY), for instance, is a play on the popular S&P Dividend Aristocrats index. The fund holds the 60 highest-yielding stocks of the S&P 1500, only including those that have raised their dividends annually for the past 25 years.

The $9 billion fund, which costs 35 cents per $100 invested, yields 3.2 percent. AT&T Inc, Pitney Bowes Inc and Cincinnati Financial Corp are its largest holdings.

The iShares Dow Jones Select Dividend Index ETF (DVY) is another option. It screens companies according to their dividend per share ratios over the last five years. The $10 billion fund, which charges 40 cents per $100 invested, yields 3.9 percent. Lorillard Inc, Lockheed Martin Corp and Chevron Corp are its largest holdings.

WATCH FOR DIVIDEND INCREASES

Analysts are anticipating that a looming dividend tax increase could persuade U.S. companies to return the record amounts of cash on their balance sheets to investors.

"You have to start buying now if you think that this tax has a chance of becoming law," said Bryan Keane, manager of the $3.3 million Alpine Accelerating Dividend fund (AADDX).

Keane pointed to corporate behavior in late 2010, when dividend taxes were scheduled to return to earlier levels. Some 100 companies declared special dividends that year to return cash to shareholders ahead of the planned tax change, according to Standard & Poor's.

Other companies moved up the date of the dividend so that it would take place before rates were scheduled to change. Wynn Resorts Ltd, for instance, shifted its first 2011 payments into December 2010 so that shareholders would not face higher rates.

Keane is looking for companies he believes will issue a special dividend this time around or increase their dividends. One stock on his list: Apple Inc, which holds roughly $100 billion in cash on its balance sheet.

"This is a company that could easily offer a share buyback as well as a special dividend," he said.

The company may address calls for a dividend in its shareholder meeting Thursday, he said.

Keane also expects Visa Inc to increase its dividend this year because of the strength of its cash position. The company, which is up 14.6 percent in 2012, offers a dividend yield of 0.7 percent.

(Reporting By David Randall; editing by Walden Siew and Andre Grenon)

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