Advisors size up the potential impact of a dividend tax break.

Despite growing skepticism, the Bush administration appears determined to push ahead with its proposal to eliminate the tax on stock dividends for investors.

The long-awaited tax break, say advocates, would stamp out the much-vilified double taxation of dividends at the corporate and personal levels, encourage investment and maybe even help put a little sizzle back in the stock market.

At this point, with the proposal's future uncertain and some important details still undecided, any changes to investment strategy based on tax-free dividends would be premature. "We've gotten some calls from clients about the issue, but we're not altering our investment plans," says Karen Altfest of L.J. Altfest & Co. in New York. "We're just talking things through right now."

Still, the plan has enough support to bear close watching. As the drama on Capitol Hill unfolds, financial advisors can start mapping out potential near-term investment strategies should it pass and digesting some of the long-term implications for the financial markets.

Bonds Face Competition

Puny interest payments, and the threat of price deterioration for bonds should interest rates rise, have some financial advisors eyeing tax-free dividends as an attractive income option for retirees. "Low interest rates have been murder on my retired clients who depend heavily on income from their portfolios," says Henry Montgomery, head of Montgomery Investment Management in Minneapolis. "Stocks with tax-free dividends would be a nice income-producing alternative that also provides the conservative growth they need." Montgomery views such stocks as a good "stepping stone" out of bonds for some of his clients should interest rates rise and the stock market pick up.

William Batcheller, senior portfolio manager of the Armada Tax-Managed Equity Fund, agrees that stocks with tax-advantaged dividends could prove a worthy alternative to fixed-income investments, as well as a long-term ballast for the overall stock market. "As baby boomers retire, many of them will want to sell stocks and buy bonds. The ability to receive tax-free dividends would encourage them to stay in the stock market," he says.

Fixed-income managers downplay the competition the proposal would introduce. "Theoretically, you could say dividend-paying stocks would compete with bonds for investor money," says Joseph Balestrino, senior portfolio manager for Federated Investors and manager of the Federated Total Return Bond Fund. "But on a practical level, I don't think that will happen. Most people buy bonds for income, not stocks."

Balestrino also rejects the notion that companies would increase their dividends enough to provide solid competition for bonds. "Companies that don't pay dividends might start to pay a small one, but they won't change the way they do business," he says. "If management has determined that a company should reinvest its earnings to grow, the tax status of dividends won't radically alter that."

At the same time, Balestrino says the yield gap between stocks and bonds could narrow if more companies start paying dividends. "Right now, the S&P 500 Index yields just under 2%, compared with a 5% or 6% yield on a high-quality corporate bond. It's possible that the index might yield half as much as that bond if this comes to pass."