Taxes And Dividends

by: David Fry

12-5-2012 3-44-42 PM IRSThere has been a rush from ETF sponsors to issue dividend ETFs as investors, particularly baby boomers, seek more income and less volatility in their portfolios. Every ETF sponsor has issued as many dividend-focused ETFs as possible (there are at least 25) to cover sectors both foreign and domestic. These ETFs have quickly gathered substantial assets, with (NYSEARCA:VIG) having the highest AUM of roughly $11 billion as of today.

However, now the taxman cometh as White House proposals on the fiscal cliff are assumed to include raising tax rates on dividends from 15% to ordinary income. If this becomes law, it will be a negative for individual investors outside their currently tax-exempt retirement accounts. And, if the U.S. goes over "The Cliff," a deal of some sort may be postponed until the first quarter of 2012. But whenever a deal is reached, and it includes raising rates on dividend income, it will be similar to previous tax increases being retroactive to January 1st.

As a consequence, more than 70 companies are now issuing special dividends payable before year-end 2012. Naturally, this is a positive initially for holders of record for any security. However, it is also a negative, as it deprives companies of "cash" that might have been used for company growth, which could include research and development, expansion of plants and facilities, marketing, and so forth. Capturing the dividend before year-end is attractive to some investors, but stocks generally decline by the amount of the dividend on payment date. Also, issuing these high dividends now primarily benefits company insiders owning low-cost basis shares who would receive a windfall much like a year-end bonus. As an example, Jim Sinegal, the co-founder of Costco (NASDAQ:COST), is the owner of 2 million shares of his company at a low-cost basis. The company declared a $7 dividend, which for Sinegal will amount to a nearly $12 million after tax return -- more than just a year-end bonus. To do this, the company sold $3.5 billion in debt to make this payment. As a consequence, Costco was downgraded recently by Fitch from AA to A+.

For taxable investors like retirees, and apart from tax-exempt investors, they may be more drawn to municipal bonds for their income needs. While some might argue municipal bond yields are too low, I would suggest this might be true given real inflation data apart from government reports. One thing I've learned over 40 years of investing and having been a municipal bond principal is that many investors hate taxes beyond credit ratings or yield. They will buy muni-bonds whether they're 1% or 5%.

See our list of Top 10 Municipal Bond ETFs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.