The $318-billion, 10-year tax cut signedinto law by President Bush on May 27,2003, is a small step in the right direction.One of the most interesting parts of theact is the tax cut on dividends. The reports that the new law willlower the tax rate on dividends and long-termcapital gains to 15%. Previously,capital gains on investments held formore than 1 year were taxed at 20%,while dividends were taxed as ordinaryincome at federal tax rates as high as38.6% for the top income earners.
Though there is a 25% cut on long-termcapital gains, the real relief formany physician-investors comes in theform of the dividend tax cut. At thehighest of rates, capital gains rates werecut a whopping 61%.
This tax reduction doesn't apply to theinterest paid on the bonds of those samecorporations. Doing so would cause, inessence, a "double tax break" rather thandouble taxation. Similar to mortgageinterest, a corporation can deduct the interestit pays on all forms of their debt,including publicly traded corporate bonds.
Besides the obvious positive aspects forthe ever-growing investor class, this tax acthas far-reaching ramifications that mightcause a physician-investor to rethink theirinvestment and asset allocation strategy.
First, municipal bonds (munis) are notas attractive anymore. Once trumpeted fortheir federal and sometimes state tax-freeincome, municipal bonds have lost someof their luster, though not all. The tax cutpackage does not eliminate taxes on corporatedividends; it simply cuts them. Iftaxes were totally cut on corporate dividends,municipal bonds would lose theirprimary selling point—federal tax-freeincome. Still, municipal bonds and municipalbond mutual funds are much saferthan common stock investments, whileoffering federally tax-exempt income.
Second, steady blue chip companieswill be rewarded. This dividend tax cutshould give a great boost to large capblue chip stocks that have a history ofpaying large and steady dividends.Though most stocks pay no dividends ordividends with yields less than 2%, thereare hundreds of stocks whose yearly dividendsyield over 5%. After an investigationof their financial long-term viability,you and your financial professional canprobably come up with some long-termdividend-paying companies that fit yourfinancial goals and objectives.
SMALLER RIPPLES FELT
Young, growth-oriented investors willsee little change. Unfortunately, the dividendtax cut will do little for youngerinvestors who invest primarily in growingcompanies. These companies usuallydon't pay out dividends. Rather, theyretain them in order to finance futuregrowth. However, small companies cangrow into large, dividend-paying companies,and young investors may be able toreap benefits down the road.
Lastly, how will non-dividend-payingcompanies react? Since the burst of thetechnology bubble in 2000, almost allnon-dividend-paying growth companieshave seen drastic declines in their stockprices. In order to bid up these prices,will some small cap companies offer dividendssolely to attract investors? If theydo, what will this mean for growthprospects? The main reason growth companiesgrow, regardless of the marketprice of their stock, is because of thereinvestment of their net income at thesacrifice of paying a dividend.
Take a very cautious look at small capcompanies who now attempt to offer adividend. A few years down the road, theoffering may lead to a no-growth, andeventually a no-dividend company.
Overall, this capital gains and dividendtax cut is a fantastic way to warm theshocked investing public back to the market.After delusions of fantastic, yetunfulfilled growth prospects of unprovencompanies in the late '90s, this tax cut is acatalyst for a renewed focus of quality,which is where it should always be.
James Douglas Matternalways
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