Playing by a Possible New Set of Rules

The Bush administration’s plan to eliminate taxation of dividends, unveiled last week, may have reminded some aging baby boomers of a classic 1970s-era comedy album by the Firesign Theatre troupe.

The title was: “Everything You Know is Wrong.”

Much of what individual investors have been told seemingly forever about constructing a portfolio appeared to fly out the window.

For starters, cash dividend income from companies -- long disdained or ignored by many people -- suddenly could have tremendous appeal.

“Everything I’ve been doing for 30 years has been to get people to avoid dividend income” in favor of capital gains, said Robert Willens, a tax expert at brokerage Lehman Bros. in New York. “You have to turn your thinking 180 degrees now.”

Likewise, the boilerplate advice to invest as much as you can via tax-deferred retirement accounts such as 401(k) plans seems to have been upended.

Now there may be a very good reason to invest in stocks through taxable accounts: Not only would dividend income be tax exempt if the Bush plan becomes law, but even companies that don’t pay dividends would be able each year to give shareholders a credit, of sorts, against future capital gains taxes.

By contrast, money in 401(k)s and similar plans grows tax-deferred but is fully taxed when withdrawn.

The caveats in all of this are many and substantial, however -- starting with the usual warning about proposed changes to tax laws: They aren’t a done deal until Congress says OK and the president signs them. The Bush plan is a long way from enactment.

Nonetheless, the idea of ending taxation of dividends does constitute a radical change for the investing world. It already has triggered spirited discussions and there will be much more debate to come.

The proposal may be just what was needed to break many investors out of the trance they’ve been in for the last few years. As stocks have suffered their worst losses in a generation, with key market indexes falling for three straight years, a common response on the part of individual investors has been no response at all. People have been frozen in disbelief, neither selling stocks nor buying more.

The prospect of a major change in the tax treatment of dividends could force investors to reconsider what’s in their portfolios and whether it’s time to prune, rearrange or restock.

Putting aside the political issues in the debate -- whether ending taxation of dividends would be a “fair” tax cut, for example -- here are some of the questions that are likely to be part of investors’ focus as they consider how the plan might affect them:

* Does the proposal make stocks more attractive investments? The market’s initial response would seem to suggest that’s the case. The details of the Bush proposal began to leak out at the start of the year. Stocks surged on the first trading day of 2003 and the rally continued last week. The Dow Jones industrials ended Friday at 8,784.89, up 5.3% year to date. The Nasdaq composite, at 1,447.72 on Friday, is up 8.4% this year.

The Bush administration says its plan would fix the “double taxation” of dividends that has long vexed many critics of the tax code: A company is taxed on its profit, then any dividends it pays out of profit are taxed when received by investors.

Economists look at this unemotionally: If investors were counting on a certain level of return from stocks over the next decade or two, the absence of taxation of a large chunk of that gross return means the net return would be higher than what people were anticipating.

The Bush administration estimates that investors would keep $20 billion more in dividend income this year if those payments no longer were taxed.

All other things being equal, then, investors probably would decide that stocks are worth more than they might have thought, say, two weeks ago.

But investors’ view of the value in stocks longer-term will depend on more than whether dividend income will be untaxed, of course. How fast will the economy and corporate earnings grow? Will the United States become embroiled in a long war in the Middle East? What will happen with interest rates? All of these questions are part of the equation as well.

* Would the end of dividend taxation mean a cash windfall for shareholders? Yes, no and maybe.

Dividends now paid by companies would be free of tax (assuming the company itself paid federal tax on its earnings for the year), so the effective income yield of stocks with dividends automatically would be higher.

Say an investor pays $40 a share for a stock, and the company pays an annual dividend of $1 a share. The annualized yield therefore is 2.5% (the dividend divided by the stock price).

If that yield is tax exempt, the investor would keep all of it. By contrast, if an investor owns a bank savings certificate yielding 2.5%, and the investor is in the 33% federal marginal tax bracket, the net return on the CD would be about 1.7%.

To look at it another way, to match a 2.5% tax-free dividend yield, that investor would have to earn 3.73% on a taxable CD.

When the Bush administration first floated the dividend tax exemption, the expectation was that many companies would be compelled to boost their dividends to make shareholders happy.

That still may happen, but another element of the Bush plan would allow companies to hold on to earnings (instead of paying them out as dividends) and still give shareholders a tax benefit.

Under the plan, companies could declare a “deemed dividend” each year -- earnings that were eligible to be paid out but were retained for expansion or other purposes. That deemed dividend would raise shareholders’ cost basis in their shares, so that any net capital gain when they sell their shares would be reduced.

“It’s a back-door capital gains tax cut,” said economist William Dudley at Goldman Sachs & Co. in New York.

That would allow many companies -- particularly in the technology sector -- to justify not increasing their dividend payouts, experts say.

On the other hand, chief executives and other corporate managers who also are substantial shareholders in their own firms could give themselves a big tax-free bonus each year by paying a dividend, or raising the dividend.

* Could some stocks become more appealing to income-oriented investors than bonds? It’s possible, but investors would have to be very careful.

Right from the start, it wouldn’t be difficult for the dividend yields on many blue chip stocks to beat yields on Treasury securities. The current yield on a five-year T-note is 3.12%. The yield on General Electric Co. stock now is about 3%. If the GE yield is tax exempt, for most investors it would beat the T-note yield (which is federally taxed).

Yields on some stocks also might be higher than what’s available on tax-free municipal bonds.

But investors would have to remember that common stocks generally shouldn’t be purchased by people whose primary goal is capital preservation with income. High quality bonds will always offer far more safety of principal than stocks. Over the last two decades, plenty of companies that paid handsome dividends wound up in Bankruptcy Court, wiping out every cent of their shares’ value.

Still, investors who can handle the risk should note that dividend-paying stocks can offer something that bonds can’t: a rising level of income each year.

Assume you buy a stock for $20 a share, and it pays a 50-cent-a-share annual dividend. The initial yield therefore is 2.5%. If the company grows and increases its dividend each year, the yield on your original purchase rises accordingly. If in eight years the dividend is $1 a share, the yield on the original shares purchased would be 5%.

* Would a tax exemption for dividend income ruin the appeal of owning stocks in tax-deferred retirement accounts? It might hurt the appeal, but many investors probably would still find there are powerful reasons to continue buying and holding stocks in tax-deferred accounts, financial advisors say.

It’s true that any tax exemption for dividends would effectively be lost in a tax-deferred account. The dividends accumulated in such an account would be taxed as ordinary income when withdrawn in retirement, along with the rest of the assets in the account.

But in the case of 401(k) plan contributions and deductible individual retirement account contributions, there’s an upfront advantage in that you’re reducing your current tax load by investing through those accounts (i.e., the money contributed lowers your taxable earnings).

Another way to think about it: You have more dollars to invest today by using pretax income than if you paid tax on that income and then invested in a non-tax-deferred account. That boosts the potential for bigger gains over time through compounding.

What’s more, if your employer matches your retirement account contribution, then forsaking the account effectively leaves free money on the table.

Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to: www.latimes.com/ petruno.