The Newest Threat to Dividend Stocks

Dividend stocks have never been more popular. With interest rates on most competing investments at rock-bottom levels, dividend yields remain attractively high -- almost unimaginably high in many cases. Regardless of whether it's a smart move from a risk perspective, investing in dividend-paying stocks is probably the only thing giving many investors the income they need from their hard-earned nest eggs.

That could all change, though. With the new proposed federal budget, a much larger tax penalty for dividends could push the pendulum back toward alternative methods of returning capital to shareholders -- methods that haven't worked nearly as well historically.

The budget and you
Yesterday's proposed budget for fiscal 2013 included provisions that would mark a policy reversal for the administration. Previously, the budget for the current fiscal year had suggested setting a new maximum rate on dividend income of 20%, matching the level of capital gains taxes that applied before the 2003 tax cuts took effect.

But now, the budget would send dividend tax rates all the way up to ordinary income rates for couples earning $250,000 or more and singles earning $200,000 and above. That would push the top tax rate on dividends up to nearly 40% -- not including the proposed surtax connected with the health-care reform law from 2010.

Companies fighting back
It's not just taxpayers that are fighting the new proposed dividend tax rates. Many high-profile companies are also backing opposition as part of more general concern about the uncompetitive state of U.S. taxation on businesses compared to other nations.

The Alliance for Savings and Investment claims as its top priority "making permanent today's current low tax rates on capital gains and dividends" as a boost for investors and the overall economy. The group, which includes Frontier Communications (NYS: FTR) , Altria (NYS: MO) , and Windstream (NAS: WIN) , argues that private investment is the key to economic recovery and job growth.

Of course, those companies and many of the group's other members would be at the epicenter of the proposed tax changes. As high-yield dividend stocks, their shareholders would take the biggest hit from a dividend tax hike.

End of a trend?
Leaving aside the fairness of such a tax, increasing taxes on dividends would likely put a stop to the decade-long trend toward higher dividends. Following the 2003 tax-law change that established lower rates for dividends, corporations suffered less from the double taxation of dividend income and therefore were more willing to pay dividends. That in turn gave investors, rather than corporate executives, the decision-making authority about whether to reinvest that cash into more shares of stock or use it for other purposes.

With high dividend taxes, corporations will likely go back to doing more share repurchases. Unfortunately, they've done a horrible job of timing those purchases, often buying back shares at exactly the worst time for shareholders.

Of course, some companies will be unaffected by higher dividend taxes. Mortgage REITs Annaly Capital (NYS: NLY) and Chimera Investment (NYS: CIM) already saddle their shareholders with ordinary-income rates on their payouts, because their dividends generally don't qualify for the preferential rate. A number of other stocks and other income-producing investments similarly incur higher tax rates.

In addition, you can always invest within tax-favored retirement accounts to avoid a higher tax bite. In fact, the end of preferential dividend rates will make owning stocks in IRAs and 401(k) plans more attractive, because you'll no longer have a disparity between the lower rates that apply in taxable accounts versus the higher rates that apply to withdrawals from IRAs and 401(k)s in retirement.

Be ready
Regardless of higher taxes, investors should be wary of letting corporations take away the cash they receive through dividends. With billions of dollars sitting in corporate coffers, the opportunity for mismanagement is so great that I'd argue you should take a highly taxed bird in hand over a possibly squandered two in the bush.

In the end, of course, the best stocks will provide outstanding returns even if tax rates go up. But first, you have to find them. Please accept my invitation to read The Motley Fool's latest special report, in which you'll find three attractive stock ideas for long-term investors. The report is free -- but don't wait: Click here and read it today.

At the time thisarticle was published Fool contributor Dan Caplinger prefers his dividends untaxed, thank you. You can follow him on Twitter here. He doesn't own shares of the ETFs mentioned in this article. The Motley Fool owns shares of Chimera Investment, Altria, and Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never taxing.

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