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Stocks, bonds, real estate. While there are other places to invest your money, these three asset classes are by far the most popular. While all three assets have been used to produce both capital gains and income, only real estate income held any tax advantage. Now with the May 2003 changes in tax law, stock income (dividends) is on equal footing with real estate income in terms of the tax breaks.
Over the last eighty or ninety years dividends have accounted for over 40% of all investment returns from stocks, a fact completely ignored during the speculative boom of the late 90’s. In fact, stocks that paid dividends also had higher capital gains than those that did not give a dividend payout during this time. At the low point in 2000 the S&P 500 dividend rate was 1.2% compared to a 4% historical rate (we are now back up to 1.7% and rising). With the new tax law, dividends are in again and many companies that historically have never paid out a dividend, such as Microsoft, are now seriously considering adding a dividend.
Why all the fuss about dividends? Prior to the new law this year dividends were taxed at ordinary income rates, whether 15%, 28% or 39%. But gains on assets held for a year were only taxed at 20% or lower, depending on your tax bracket. Not only did the new tax law reduce the ordinary income tax rates, and the capital gains rates, but it also allows the dividends on assets held more than sixty days to be taxed the same as long-term capital gains rates.
Here are the details: If your ordinary income falls into the new 15% bracket or below, both your long-term capital gains and dividends are taxed at only 5% from May 5, 2003 to December 31st, 2007. In 2008 only there is zero tax on gains and dividends for the 15% bracket and below. If you are above the 15% ordinary income bracket, both your dividends and gains are taxed at 15% through 2008, even if you are in the highest 35% ordinary income bracket. In 2009 the tax break expires, but the thinking is that it will be very difficult politically to restore the higher tax rates, and it is expected that between now and 2009 that more legislation may pass to permanently reduce these investment tax rates.
So what does this mean for me if I don’t need or want income? Many investors in higher tax brackets that didn’t need income actually stayed away from dividend-paying stocks to avoid paying up to a 39% tax rate, and chose companies that did not pay a dividend so that their maximum tax exposure was only 20%. Now all stocks, with or without dividends, are on an equal footing. Investors, whether investing for growth or income, will pay the same tax rates. This should result in a whole new group of investors buying dividend-paying stocks that previously ignored them. This is expected to create a long-term demand for dividend-paying stocks that should benefit owners of such stocks, whether invested for growth or income. I believe dividend-paying blue chip stocks will be the investment of choice for the next five years at least.
What if I do need income? Stocks are now a very attractive way to get income. Bonds are still taxed at ordinary income rates. Bonds are currently paying record low-income yields and are at record high prices (low return with high risk). Higher taxes, higher risk and lower return equal lower demand. For income-oriented investors, REITs (Real Estate Investment Trusts) and dividend-paying blue chip stocks offer tax advantages and much better expected capital gains than the fixed income alternatives. Stocks like General Motors, Albertson’s and Bristol-Myers Squibb offer dividends rates of around five percent and should also produce significant capital gains over the next few years. Investors in lower tax brackets can take advantage of the new tax law and would only pay federal taxes of $250 on $5,000 worth of dividend income compared to taxes of $750 to an equivalent amount of bond income. Higher tax brackets garner even more dramatic savings. An investor in the 35% bracket would pay $1,500 in taxes on $10,000 in dividend income, but would pay $3,500 in taxes if the income came from bonds, a difference of $2000.
The Tax Relief Act of 2003 makes stock dividends much more attractive than bond income. This should result in higher long-term investment returns from dividend-paying stocks for both growth and income investors. If you are willing to put up with the short-term volatility of stocks, you can now have your cake and eat it too. One way to mitigate the higher risk and volatility of stocks is to not chase the highest dividend, but to invest in large, stable companies with growing significant dividends. Prudent investors are now doing this, which is the reason many companies are now considering adding a dividend payout. Dividends matter again, and the trend of rising dividends should continue through at least 2008.
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