Pockets of opportunity exist for investors.

Ever since Congress passed the tax-cut package in May that reduced the tax rate on qualified corporate dividends from a maximum of 38.6% to 15%, these once-dismissed stock sweeteners have made a comeback. Consider that:

This year, public companies have fattened dividend payouts and will probably continue doing so in 2004, when Standard & Poor's predicts that S&P 500 Index dividends will rise an estimated 10%.

Investors seem to covet higher dividends and lower taxes. Forty-three percent of respondents to a recent survey of 600 individuals conducted by American Century Investments said they are more likely to buy stocks that pay dividends qualifying for the new tax rate. Thirty-eight percent said they are more likely to take dividends into consideration when buying a stock fund, while 37% indicated they now view dividend-paying stocks as an alternative to fixed-income investments.

Despite the market's recent preference for growth stocks over more sedate dividend-paying fare, there is still strong evidence that the turtles often win the race. The Dow Jones Select Dividend Index, which invests in the 50 companies with the highest dividends in the broad-based Dow Jones U.S. Total Market Index, has had an average annual return of 6% over the last five years and 11% over the last decade. The index from which it is derived had annualized returns of -1.13% and 8.46% over the same respective periods. From a valuation standpoint, stocks with above-average yields still sport lower valuations than lower-yielding growth stocks.

Few Investment Options

But getting a measurable level of tax-favored dividend income is no simple matter. The skimpy yield for the S&P 500 Index means that investors often need to troll among tobacco stocks, utilities, depressed turnarounds and other deep-value fare to get yields over 2%. Absent further legislation, the reduced maximum rate on qualified dividend income (as well as long-term capital gains) will disappear after December 31, 2008, making the longer-term outlook for high-yielding stocks uncertain. A limited number of high-dividend investment options beyond individual stocks pose a more immediate concern.

Relatively few mutual funds, including those in the equity income category, offer dividend yields significantly above the market averages. Since funds take out expenses from the income their portfolios generate-first from non-qualified dividend income and then from the side that qualifies for favorable tax treatment-high expenses can wipe out a good chunk of a portfolio's dividend yield, if not all of it.

Low expenses provide no assurance of high dividend income, either. Many funds pursue a dividend growth strategy by focusing on companies that look poised to grow their dividends, rather than on stocks that already have above-average dividend yields. While such a strategy has merit, the portfolio it creates will probably generate dividends that qualify as a side dish rather than a main course.

Tax issues complicate matters further. Dividend distributions from many funds fail to meet the holding period requirement, which specifies that a stock must be held for at least 61 days during the 120-day period beginning 60 days before the ex-dividend date. If the fund fails to abide by those guidelines, the dividends are taxed at higher ordinary income rates. Fund dividends attributable to income from REITs, money market securities, taxable and tax-exempt bonds and some preferred and foreign stocks are also taxed at higher rates.

The good news is that fund dividends may be eligible for favored tax treatment if they are attributable to stocks that pay qualified dividends, and the fund follows the necessary holding period rules for those stocks. Dividends from U.S. common stocks, and the mutual fund dividend distributions attributable to them, are generally eligible if the fund meets the holding period requirement. Because the new rate applies retroactively to dividends received at the start of 2003, mutual fund tax forms now separate qualified dividend income from short-term capital gains and non-qualified dividend income taxed as ordinary income. Some fund company Web sites, such as Vanguard, list the percentage of each of its funds' income that qualifies for the low dividend tax rate.

Pockets Of Opportunity

Despite a limited menu of high-dividend, tax-favored investment options, there are pockets of opportunity for fund investors, says Sheldon Jacobs, publisher of The No-Load Fund Investor in Ardsley, N.Y. In his December 2003 newsletter, Jacobs singles out the Schwab Dividend Equity Fund as a top high-dividend equity fund choice. Launched in September 2003, the actively managed fund's mission is "to provide current income from dividends that are eligible for the reduced tax rate on qualified dividend income." Its managers identify the 1,500 largest, publicly traded U.S. companies, then narrow the focus to those that pay dividends. From that list, they invest mainly in stocks with the highest Schwab Equity Ratings. The fund had a recent 30-day SEC yield of 3.18%, aided by a 0% expense ratio that is guaranteed until May 2004. After that, an expense ratio of 0.95% for Select Shares and 1.10% for Investor Shares is guaranteed until February 2005. The fund must be held for at least 180 days to avoid a Schwab transaction fee.

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