net worth
Take A Look at Dividend Payers
The new tax laws now make dividend-paying stocks a more appealing choice than ever before.

Since the passage of President Bush's 2003 Tax Act, we've received several questions asking how investors can benefit from the new tax law reducing the tax on dividends. In this month's column, we'll try to provide some practical answers that might boost the overall return on your own portfolio.

The Tide Has Turned

For decades, investors seeking capital appreciation over longer time horizons have migrated toward stocks paying little or no dividends in hopes of locking in appreciation at lower capital gains tax rates. Now, the 2003 Tax Act changes all that by lowering the tax rate on dividends from 38.6% to 15% -- a 61% reduction. The rate applies to qualifying dividends received by individuals after 2002.

Qualifying dividends are dividends from U.S. domestic corporations and from certain foreign corporations. Generally, a dividend won't be considered to be qualifying if the stock is held for 60 days or less. Ordinary income dividends from mutual funds will be taxed at the preferential rate, generally, to the extent the mutual fund earns qualified dividend income.

For the first time in several decades, the tax law is indifferent as to how you earn your income on stocks, whether it's from dividends or capital gains.

Intuitively, this makes perfect sense. Over longer time horizons, stocks generate better returns than any other asset class, but with quite a bit more volatility along the way. In valuing stocks, a company's shares generally should sell for a multiple of what it earns in cash flow. Therefore, if a company now decides to share that cash flow with its investors via a dividend, the investors will be rewarded by simply holding onto the stock and collecting the regular cash payouts.

This emphasis on dividends will encourage stock valuations more in line with traditional valuation principles and not in accordance with now-discredited late 1990s valuation methodologies based on often unrealistic growth projections that were never met.

Changing Policies

Microsoft has traditionally been a quintessential growth stock, paying no dividends in its roughly 28-year history. Maybe it's coincidental, but Microsoft, which said in January that it would declare its first dividend in history -- 8 cents annually -- increased the payout to 16 cents after the new tax law went into effect. Viacom, parent company of Blockbuster, cited the tax law change when it announced it would begin paying a 24-cent annual dividend, its first since 1987. Many other companies have agreed to pay a dividend, many citing the new tax law as a reason for instituting one.

During the late 1990s bull market, the dividend yield on the S&P 500 stocks sank to a low of about 1%. We anticipate that the market will bid up the prices of these larger companies, a direct result of the tax law reducing taxes on dividends. This will in turn drive down their yields. If you consider the dividend rate as a percentage of your original investment, rather than calculating yield by the current market price, rising stock prices will give you the twin benefits of a healthy dividend plus capital gains.

Boomers Like Dividends

Baby boomers are looking forward to enhancing their retirement incomes while simultaneously increasing the value of their underlying investments and reducing volatility. With fixed income yields at or near historical lows as well as the virtually non-existent yield on money markets, we expect dividend income to play a much more prominent role in boomers' retirement portfolios.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., is president, and Anita S. Frank, CPA, tax manager, at The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group {(713) 627-7660} provides personalized, fee-only financial planning, investment management and business consulting services.