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More than just rich could benefit from dividend plan

Updated: May 3, 2013 12:14PM

Originally published: January 16, 2003

Looking for some tax-free income? You don’t have to be rich to find that idea appealing. Just ask any plumber or electrician to do a job for cash. Bet you’ll get a quick answer.

The same idea applies to municipal bonds. Billions of dollars of tax-free bonds and bond funds are purchased by investors who don’t define themselves as rich. They’re just looking for the tax-free income.

Ditto the appeal of Roth IRAs to young workers. And Section 529 College Savings accounts to young parents. In both of these savings products, the gains come out tax-free. And you don’t have to be rich to find that appealing.

So why is it shocking to assume that people would buy stocks if they could receive tax-free dividend income? Everyone, rich and middle-income, retired and still working, would be attracted to tax-free income, and would consider buying stocks.

The stock advantage

In fact, if stock dividends were tax-free, stocks would have two big advantages over municipal bonds, if you’re willing to take some additional risk.

When you buy a municipal bond, the coupon interest rate is fixed for 20 or 30 years. Future inflation could wipe out the value of that quarterly check. But companies can increase dividends every quarter. And the successful companies probably will.

The second advantage: When you buy a municipal bond, you get back your original $1,000 investment in 20 or 30 years. But the value of your stock could be worth far more in the future. Yes, it could also be worth far less. But that’s the risk you might be more willing to take if you’re receiving tax-free dividend income over the years.

Is the dividend proposal just a way to make stocks more attractive so the wealthy can change their asset allocation?

Not at all. Rising stock prices actually create wealth over time. And a lot of definitely non-wealthy workers putting money into their 401(k) plans and IRAs will become wealthy if stocks are more attractive in the long run.

There is some concern that other tax-free investments might suffer if stock dividends became tax-free. Municipal bond prices have fallen slightly in the last few days because of concerns they’d lose their appeal.

And would people continue to invest as much in retirement plans? After all, when money is withdrawn from retirement plans it is all taxed as ordinary income--including the accumulated dividends.

But a study just released by T. Rowe Price says even with the tax break on dividends, the advantage of investing pre-tax money in a retirement plan will still outweigh investing outside the plan.

There is one group of investments--tax-deferred variable annuities and the brokers who sell them--that might be hit hard by the dividend proposal. In these annuity products, you invest after-tax dollars to grow tax-deferred in investments similar to mutual funds. Just like a retirement account, all of the money is taxed as ordinary income on withdrawal; there’s no deduction for investing in an annuity. In a world where dividends aren’t taxed, the advantage of tax-deferred growth inside a variable annuity slips away, according to the T. Rowe Price calculations.

Still, the political debate continues about whether the dividend plan is a giveaway to the wealthy who own stocks. The far-sighted realize that the debate over tax-free dividends is not about who’s collecting dividends now, but about who might be enticed to invest in the future.

Impact on stock prices

How much impact could eliminating double taxation of dividends have on the stock market?

Everyone has an estimate--ranging from “modest” to “major.” It all depends on the assumptions.

But one assumption that’s clearly wrong is the assertion that only wealthy people will benefit from tax-free dividends. The Savage Truth is that anyone who wants to become wealthy would benefit from eliminating the tax on dividends. And that group includes just about everybody.

Terry Savage is a registered investment adviser and is on the board of directors of McDonald’s Corp. She appears weekly on WMAQ-Channel 5’s 4:30 p.m. newscast.

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