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."

The first fixed-income battleground would likely be municipal bonds, since their tax-free interest payments make them favorites of income-oriented investors. Some think the proposed change would put them in direct competition with tax-free stock dividends. Adding to that potential problem, many municipal issuers have experienced severe downturns in tax revenue and credit downgrades.

Making dividends tax free would add even more revenue erosion to the equation, since most states figure their income taxes based on adjusted gross income reported on federal returns. If dividends aren't counted in the AGI calculation, states would get less tax revenue unless reporting methods changed. "Some states are in bad shape now," says Stephen Carpenter, vice president and senior portfolio manager at National City Bank in Cleveland. "This would just add to the problem."

Yet Carpenter maintains that the long-term effect would be minimal, and that the economic stimulus provided by the tax cut would help offset the revenue loss. "As an asset class, municipal bonds are fairly stable," he says. "I just don't believe that people who buy municipal bonds are the same ones who will run to the stock market."

High yields relative to taxable issues might help persuade them to stay put. "A ten-year, triple-A rated municipal bond has a tax-exempt yield of 3.8%, about 92% of the yield on a ten-year Treasury bond," says Carpenter. "The 1.7% dividend yield of the S&P 500 isn't in the same ballpark."

Stocks: Juicier Dividends

Stocks with high dividend yields in sectors such as utilities, telecommunications and energy enjoyed a nice "pop" in January after President Bush announced the tax proposal. But stocks that pay little or no dividends, as well as the overall market, could also benefit in the longer term.

"If the tax on dividends were lowered or eliminated, I know that a lot of companies in my portfolio would like to double or triple their dividends, or start paying them," says Blaine Rollins, manager of Janus Fund. Maxim Integrated Technologies, one of the fund's largest holdings, paid its first dividend in November in response to increased investor demand for dividend-paying stocks. In January, cash-rich Microsoft declared its first dividend of 16 cents a share. While that represents a dividend yield of less than 0.3%, it opens the door for institutional investors and mutual funds limited to investing in dividend-paying stocks.

Jeff Van Harte, head of equities for Transamerica Investment Management in San Francisco, says a number of the growth stocks he invests in are generating large amounts of cash and would be able to pay a dividend without impacting their growth rates. Yet he characterizes the potential impact on the overall market as relatively subdued.

"Reducing or eliminating the tax on dividends would produce perhaps a 5% to 10% increase in overall stock prices," he adds. "The bigger impact would come if it helps companies make better capital allocation decisions. Many of them destroyed shareholder value by using their cash to make ill-fated acquisitions. This would force them to re-evaluate those strategies."

The most obvious and immediate beneficiaries of a reduced or eliminated dividend tax would be companies that already pay a dividend. Patrick Horan of Horan & Associates in Towson, Md., says dividends are not a primary consideration for him, but a number of stocks he owns offer above-market yields that would be made more attractive by tax-free status. His holdings include catsup and food producer H.J. Heinz, which has a 4.82 % dividend yield and sells at just 15 times estimated 2003 earnings. "This isn't a huge grower, and it's had some management issues," he says. "But it's a brand name with a good product line and a solid history of earnings."

The proposal has not resulted in much attention for real estate investment trusts (REITs). Because REITs pay out the lion's share of their income as dividends, they are not taxed at the corporate level and would probably not be included in the Bush proposal. This could make them less attractive relative to other stocks that produce dividend income.

With interest in dividend-paying stocks piqued by their bear-market resilience and recent tax-related developments, mutual fund evaluation services have been showcasing their top-pick stock funds that pay high dividends. Morningstar Inc. of Chicago has created a list of four funds in this category that have strong management, low costs and proven track records: American Funds Washington Mutual, T. Rowe Price Equity-Income, Dodge & Cox Stock and Vanguard Equity Income.

A common denominator among all these funds is their below-average expense ratios, and with good reason. Since funds take out expenses from the income their portfolios generate, high expenses can help to wipe out a portfolio's dividend income. The 1.5% annual expense ratio of a typical U.S. stock fund is enough to drastically reduce or eliminate dividend payouts. Value funds, which typically have the highest dividend yields among stock funds, could get an early boost if the proposal passes.

One question that remains is how interest from bond and money market funds would be treated, since mutual funds receive interest payments and pay them out as dividends. According to a report by Standard & Poor's Chief Economist David Wyss, bond funds would probably need to classify dividends as "qualified" and "nonqualified," and provide a more complicated