 Dividends:
Naughty or nice?
|  Dear
Dr. Don,
What is the real benefit of receiving a money dividend
from a stock if the stock price declines by the amount of the dividend
payment? Aren't you just getting your money back and then you have
to pay taxes on it, too? -- Howard Harrumph
 Dear
Howard,
Actually, your premise is wrong. Stock prices
don't decline by the amount of the dividend payment. If XYZ Corp.
pays out a $5 dividend, it doesn't mean the price of the stock will
decline by $5.
It is true of mutual funds. When a fund distributes
a dividend, the net asset value declines by a similar amount. But
stocks are more complicated.
Financial theory argues that the current value of
a stock represents the present value of all its future dividends.
So, when a stock pays a dividend, you might expect its price to
fall by the amount of the dividend. The problem is that the stock
market is dynamic, and you can't look at the dividend payment in
isolation.
Regardless of the validity of this theory, investors
have a reinvestment problem when they are investing for future financial
goals and have to reinvest dividend payments. A corporation with
a dividend-reinvestment plan will allow you to reinvest the payment
as fractional shares of stock, but you'll still owe taxes on the
distribution.
Dividend-paying stocks got a real boost with the 2003
change in the federal tax code. Qualified dividend payments are
no longer taxed as ordinary income. Dividends are taxed at a 15-percent
rate for most individual taxpayers, but low-income individuals pay
a 5-percent tax on dividend income through the end of December 2007.
Low-income individuals will pay no taxes on dividend income in 2008.
In 2009, the tax changes sunset and dividend income is once again
taxed at ordinary income rates. IRS Publication 550, Investment
Income and Expenses, has more on dividend taxation.
The argument against dividend payments is that if
you don't need the income, the company can hold on to the money
as retained earnings and keep it invested while deferring any personal
income tax. As long as the company has productive places to invest
the money, why not let it hold on to the funds?
If you own individual stocks you can always vote with
your feet and choose companies that don't pay dividends and sell
them when they start paying a dividend. In finance theory it's known
as the "clientele effect" for dividends when income-oriented
investors own dividend-paying stocks and growth-oriented investors
own stocks that don't pay a dividend.
Some investors prefer dividends because of the "bird-in-hand"
aspect of stock returns. You have to sell a stock to realize a capital
gain, but dividends give you a return on your stock investment without
selling the shares.
Jeremy Siegel, Wharton professor, in his new book,
"The Future for Investors: Why the Tried and the True Triumph
Over the Bold and the New," discusses the importance of investing
in dividend-paying stocks as part of long-term investment strategy.
It's an interesting read on why investors should stop worshipping
at the shrines of growth and technology.
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