Dividend Investing: The Thing Is Total Return, Not Taxation

Half a loaf is better than none. Or, put another way, even paying 50 cents per dollar of investment returns isn’t fun. But it’s a lot better than earning nothing at all, and getting zilch. That’s why investors’ first priority is always to invest for returns.

The lower the tax rate is the better, of course, but buying an investment solely or even mainly because fewer taxes are due is always a prescription for mediocre returns, if not outright disaster.

Unfortunately, I have a very bad feeling that as we move through a hotly contested election year all too many investors are going to be tempted to abandon good sense in order to avoid taxes that may never be levied. In a best-case they’ll sacrifice far more in potential returns than they’ll save in what are still phantom taxes.

In a worst-case they’ll find themselves scammed by charlatans who are all too happy to prey on their fear of the future.

To be sure, there are plenty of unknowns here. Much will depend, of course, on whether Democrats or Republicans hold most of the power in Washington after the Nov. 6, 2012, elections. And there are already plenty of tea-leaf readings going on to call the election in either direction.

Certainly taxes will be a big part of the debate as the campaign unfolds. But the positions staked out by the parties at this point are just that, campaign positions. Depending on what results from actual voting some will emerge as genuine bargaining points. But at this time there’s no way of knowing which will be abandoned before the campaign has run its course.

This makes for uncertainty, which partisan media have been only too happy to inflame. And as we approach November the rhetoric is only going to become more intense, particularly as Democrats hammer home the “tax fairness” issue, which basically means taxing wealthier taxpayers to close Uncle Sam’s deficit.

My advice is simple: Continue to invest for returns, not to avoid possible future taxes. For one thing, no party is going to have a total monopoly in Washington in 2013.

Even if President Obama wins re-election and the Democrats stun oddsmakers and recapture the House of Representatives, Republicans in the US Senate will have more than enough votes to block any truly aggressive initiatives. Conversely, even if Republicans capture the Senate and White House they’ll still have to compromise with Democrats to get anything done.

The biggest mistake many bears made in 2011 was betting Congress wouldn’t be able to reach an agreement on raising the US government’s debt ceiling. Indeed, more than a few members of Congress will campaign this year on their opposition to that vote. But Washington did act and the result–despite S&P’s downgrade of Uncle Sam’s credit rating–was an unprecedented rally in US Treasury bonds that’s resulted in their lowest interest rates in history.

There have been times when some Americans found war and devastation preferable to compromise, such as the Civil War. That kind of thinking, however, is far from a majority opinion now. And it’s not likely to be after November, either.

The details of such a compromise will depend heavily on who wins this year. If Republicans win convincingly enough, both investment taxes and income taxes could well decline across the board. All remaining candidates for the nomination have endorsed cutting investment taxes, and some would eliminate them entirely.

If Democrats win big wealthier investors are going to pay higher taxes. But even then the final result almost surely fall somewhere between the current positions being staked out in the campaign. Rates would rise, but not nearly so much as has been proposed.

That’s the first point of comfort for income investors of all stripes. Some may disagree with my second point. But even if all the Democrats’ proposals are adopted, the impact won’t be nearly as great as so many seem to fear now.

For one thing, even the president has proposed cutting the statutory corporate tax rate to 25 percent from the current 35 percent rate. The president is also proposing a boost in the maximum capital gains rate to 20 percent and the elimination of preferential tax rates on dividends for Americans with annual income of more than $250,000.

Those with income below that mark would still enjoy the preferential rate, while those above would pay taxes on dividends at ordinary income rates, as they did prior to 2003.

All else equal, raising the tax rate on dividends for high-income investors would make dividend-paying stocks commensurately less attractive. On the other hand, all else is most certainly not equal, mainly because it’s total returns and not tax rates that count. And over the past decade-plus, dividends have become an increasingly important part of stock-market earnings.

Invoke the “bird in hand versus two in the bush” proverb, if you will. Paying 50 cents of taxes on a dollar of dividend income is less attractive than paying just 15 cents, as is the case now. But that 50 cents in dividend income is certain, whereas a dollar of capital gains taxed at only 20 percent is most definitely not certain.

The upshot is it’s far from clear whether or not a higher tax rate on higher earners’ dividends would decrease the appeal of dividend-paying stocks. Moreover, even higher earners enjoy ways to shelter income, such as Roth IRAs, that could make tax changes moot.

It’s also worth noting once again that there was very little upward movement in dividend-paying stocks in the immediate aftermath of the Bush tax cuts. Only as capital gains become tougher to come by and companies proved their ability to pay dividends come what may did dividend-paying stocks start to gain popularity. This makes it highly questionable we’d see a selloff of dividend-paying stocks, even if rates were raised for more investors than just the top earners.

Finally, other income sources such as bonds, annuities and savings accounts are not a real alternative to dividend-paying stocks for those living off their investments. And, contrary to stocks, these investments are already taxed at full statutory rates.

Running to them means you accept a much lower yield that’s fully taxed now, just so you can avoid the threat that you’ll pay full taxes on the much higher yields you’re earning now. And if you currently earn less than $250,000 you’re completely unaffected, even if the president gets everything from the negotiation, a highly improbable result.

Doubtless you’re going to hear counterarguments to everything I’ve written here. And I certainly don’t expect anyone to be happy paying a higher tax rate.

But if you’re really worried about paying higher taxes next year, pick up some master limited partnerships (MLP), whose favorable tax status is still not under attack. These pay distributions that are mostly return of capital, which isn’t taxed as income in the year received but only when you sell as a capital gain.

If you’re worried that dividend-paying stocks will sell off on the threat of a higher tax rate–a real possibility if enough investors panic–buy some dividend-paying Canadian and Australian stocks. They’re primarily owned by nationals of those countries, whose taxes are wholly unaffected by changes in US tax policy. Home-country buying should offset any selling by panicky Americans, if there’s any impact on price at all.

Above all, however, your focus must remain on buying high-quality stocks at good prices, and holding on to collect a rising stream of dividends. We don’t know what will happen to tax rates in 2013. But we do know that weak companies will stumble in 2012, as economic growth remains lumpy and credit conditions less than certain.

And we do know that it’s a seller’s market for bonds, with even less creditworthy US corporations issuing debt with long maturities at record-low yields. The pickings there are slim, if they exist at all, and keep in mind they’re taxed at full rates right now.

The bottom line: No matter what happens on the tax front next year, there’s no alternative for those living off investments to buying and holding a portfolio of high-quality, dividend-paying stocks.

Don’t let anything you hear make you lose sight of that.