Josh Peters, CFA, is Morningstar’s director of equity-income strategy and the founding editor of Morningstar DividendInvestor, a monthly newsletter that provides quality recommendations for current income and income growth from stocks. He is also the author of The Ultimate Dividend Playbook (John Wiley & Sons, 2008). Mr. Peters joined Morningstar in 2000 as an automotive and industrial stock analyst. After leaving in 2003 to join UBS Investment Bank as an equity analyst, he returned to Morningstar in 2004 to develop DividendInvestor. Mr. Peters holds a bachelor’s degree in history and economics from the University of Minnesota-Duluth and is a CFA charter holder.
If taxes are going higher, Josh Peters shows how you can invest and limit your tax bill.
How to plan for potential tax increases. We’re here with Josh Peters. He’s going to tell us what he sees as the best strategy for getting through what might be happening in this election year.
Yeah, it’s pretty tough what we’re looking at here potentially to start off 2013. Not just dividend taxes, but all kinds of taxes and all kinds of spending as well are all going to be reversed as a matter of law unless Congress acts. It’s got a lot of people worried, but I think it’s important to have a pretty clear head about it and understand what’s going on.
To me, there are two dimensions. One is what might happen, and my best guess is that we’re going to see some kind of reform package that’s going to address lots of areas of the tax code, both individual and corporate.
We’re probably going to see some new tax rate for upper income earners; instead of 15%, maybe it’s 20%. I don’t think it’s going to be ordinary income. I think that the government recognizes that this is income that has been taxed already at the corporate level, but there’s probably going to have to be some additional revenue rate, and it doesn’t matter who wins the election.
The second dimension is...what is it going to mean for me in the worst-case scenario, which is capital gains continue to get a break even if rates go up, but dividend rates go up a lot? If they go back to being ordinary income...I think the most important thing to remember is, what’s the alternative? If I need income, I don’t like the idea of paying higher taxes, but only dividends can give me income plus that inflation hedge and that long-term capital appreciation potential.
If I go to bonds, unless I’m looking at munis—you know looking at corporate bonds, Treasury bonds, and mortgages—all this stuff is taxed as ordinary income. There’s not a tax break that you can get or tax relief you can get by selling your dividend-paying stocks and going back to bonds. Plus the yields are so low, why would you want to do that anyway?
Even though I don’t think anybody wants to pay more taxes, this is still probably going to be the best game in town...and most people are not in the top marginal rate. If it’s money in an IRA that is receiving dividends, it’s not affected. This is a situation where if taxes go up, it could actually create opportunities for a lot of middle- and even upper-middle-class investors, if the people at the very top end of the income spectrum decide that they want to move into something else.
Right, it opens the door. Do you have any particular stocks that you like if all this comes to pass, or even sectors that investors might want to look at?
Well, there are two sectors that really don’t stand to have much effect, and that’s because they don’t technically pay qualified dividends. That’s REITs and Master Limited Partnerships.
The trouble with REITs, right now, is that they’re overvalued. Their dividends have been taxed as ordinary income all along, because REITs don’t pay taxes themselves, so they were never eligible for a tax break that’s now going away. It’s kind of a non-event, but it’s very hard to find a REIT that isn’t expensive right now.
They’ve been rallying for over a year.
There are a couple out there that I think are terrific businesses, like Healthcare REIT (HCN) or Realty Income (O). But I think you want to wait for these names to pull back a good 10% to 20% before you look at putting new money to work there.
On the MLP side, again it’s a structure that the income of the organization is not taxed at the corporate or partnership level, but is allocated down to individual partners. There, I think you do have some opportunities to buy some names at some decent prices. Kinder Morgan Energy Partners (KMP) is probably my favorite: a very well diversified partnership with lots of growth opportunities.
AmeriGas Partners (APU) is a smaller-cap name that I like. They’ve had actually a really rotten year because of such warm weather over the winter—a lot of propane gets used in heating—but there are going to be cold winters and warm winters. This is a mean-reversion type of situation, and on average I think that they cover the distribution by a good amount, and they’re able to meet their goal of raising that distribution about 5% a year.
Beyond that, when you’re looking at traditional, qualified dividend payers, you want to make sure that whatever you own heading into a potential adverse change is a company that’s going to continue to pay the dividend. You don’t want both a tax increase on the dividend and then turn out you don’t get the dividend at all, because the company just decided to stop paying it.
You know, General Mills (GIS): 114 years paying dividends. You know, they paid good dividends when the top marginal tax rate was 91%. People don’t remember it, but in most of the 50s and into the 60s, the top marginal tax was 91% in this country, and yet companies paid bigger dividends then than they do today.
My fear is for like a Cisco Systems (CSCO), which has just recently started paying a dividend. I think that it’s good that they did that. It was even better that they raised the dividend—now the stock yields around 3%. But is their commitment to the dividend with two years of paying strong enough that even if tax rates change, they’re not going to decide to just chuck it?
You know, that’s one situation that I might want to stand back. There are other reasons I think to have some concerns about dividends in the tech sector. They are better than nothing, but they’re unproven.
They don’t have the track record of staples and utilities—tobacco, things like that. But the possibility that the dividend just gets yanked away because of a change in tax policy is I think one thing that you want to be worried about.