Investing - Mutual Funds June 9, 2010, 10:30PM EST

Dividend Funds Gird for Yearend Tax Hike

The expiration of the Bush Administration's tax cuts at the end of 2010 has portfolio managers mulling strategies for how to minimize the hit to investors

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There's no question that income-oriented investors have benefited over the past seven years from the broad tax cuts the Bush Administration implemented in May 2003, which included slashing the tax rate on dividends and capital gains to 15 percent from 39.6 percent. With those lower rates due to expire at the end of 2010, fund managers focused on providing steady and rising income to investors are pondering how they can reduce the inevitable hit to their returns.

The size of the tax increase on dividends could be a key consideration in taxable shareholders' decisions whether to hold onto dividend-paying stocks. The Obama Administration budget proposal for fiscal 2011 calls for the tax rate on both dividends and capital gains to rise to 20 percent, but some portfolio managers think Congress favors a higher rate—at least 28 percent—to help pay down the ballooning federal budget deficit over the next several years. Unfortunately for investors, the Obama budget plan includes a number of other contentious items, which could cause Congress to reject it outright. That would automatically push dividend and capital-gains tax rates back to 39.6 percent on Jan. 1, 2011—where they were before the Bush tax cuts took effect—unless Congress elects to pass individual provisions in the budget. Not least of the budget features likely to invite stiff opposition is a proposal borne of the financial crisis that seeks to impose a 0.15 percent annual fee on banks and other financial institutions with $50 billion or more in total assets.

Cliff Remily, co-manager of the Thornburg Investment Income Builder Fund (TIBAX), believes the market is pricing in a dividend tax rate of 20 to 25 percent. If the rate were to default to 39.6 percent on a budget hangup, that would be "catastrophic" for companies and investors, he says, since it practically ensures that companies would cut dividends to lower the tax hit to investors. "Management is naturally biased toward cutting dividends. If they hold cash, they can either buy back shares, which props up stock options and increases earnings per share, [or have an] increased ability to do M&A, which is frequently overpriced," he says. Paying dividends lessens the potential for value-destructive capital allocation by companies, he and other fund managers argue.

New Dividend Initiation

Contrary to what one would expect, Viacom (VIA.B), owner of MTV Networks and Paramount Pictures, initiated a dividend on June 9, apparently unconcerned with the looming rise in the tax rate. Don Taylor, manager of the Franklin Templeton Rising Dividends Fund (FRDTX), believes a tax hike would tend to discourage new dividend initiation but says there are other factors—large cash balances or reluctance to commit capital to specific projects—that are probably driving Viacom's decision. Nine other companies have initiated dividends year-to-date as of May 31, while 122 others have increased their dividends since the start of this year, according to Howard Silverblatt, senior analyst for indexes at Standard & Poor's and a contributor to Businessweek.com's Investing Insights blog.

Taylor says he isn't doing anything to position his portfolio ahead of the tax hike mostly because he doesn't believe it will uniquely affect his holdings compared with the broader market. Also, "it seems to me it ought to be so well-known that it's already [priced into] the market, and there are other influences on stock prices that should overwhelm it."

He thinks the "overwhelming majority" of institutional investors probably anticipate a tax rate in the high 20 percent range for both dividends and capital gains.

If that's not the case and the market is waiting for the new tax rates to take effect before it reacts, higher-yielding dividend-paying stocks would be more vulnerable to a sell-off than lower-yielding ones since "there's just more dollars lost" on an aftertax basis, he says.