Answers to Three Important Dividend Questions

I get asked a lot of great questions — both on my blog and through e-mails — and today I want to answer three very important ones that all relate to dividend investing.

Let’s start with a major source of concern for many Americans right now …

“What Will Happen to My Dividend Stocks
If Congress Lets the Current Tax Cuts Expire?”

Pretty much every newspaper in the country has been running stories about the Bush tax cuts and whether or not Congress will let them expire at the end of this year.

However, most reporters and pundits have chosen to focus on tax brackets, and whether higher-income Americans should be forced to pay bigger tabs. I hear very little talk of how one aspect of those cuts will affect many U.S. investors — particularly retirees — regardless of their overall income picture. 

First, a quick recap: As part of President George W. Bush’s Jobs and Growth Tax Relief Reconciliation Act of 2003, which was signed into law on May 28 of that year, tax rates on both capital gains and qualified dividends were reduced to rates of 5 percent for the lowest income brackets and 15 percent for everyone else. Originally set to expire at the end of 2008, these cuts were extended through the end of 2010 with legislation passed in 2006.

Now, the question is whether or not these changes will sunset come January 1. While I can’t say what Washington will ultimately do, there are a few points I’d like to make:

First, it’s entirely possible that lawmakers will recognize the importance of dividend income to millions of older Americans, especially in this pitiful interest rate environment, and choose to extend that particular feature even if they let other aspects of the legislation expire. At the very least, I hope this is the case.

Second, even if tax rates do go up on dividends, I don’t expect a major effect on the share prices of dividend stocks. In other words, investors are not going to run for the hills or anything.

Consider the alternatives and you’ll see why: CDs and money market funds are still paying nothing … and it’s certainly better to give back more of your income than to have no income at all!

Besides, nearly any other form of investment income would be subject to the same rates going forward anyway.

A Roth IRA is one great way to shield dividend income from any future tax hike.

Third, if you’re holding dividend stocks in tax-sheltered accounts like IRAs, this is really a moot issue anyway. And even if you’re not currently holding your dividend stocks in such an account, you can probably find a way to either shift them into one now or at least make future purchases under such an umbrella going forward. A Roth IRA would be the ideal choice.

In short, I sincerely hope the lower rates stay in effect — because a change will impact plenty of Main Street investors and retirees, not merely the ultra-rich. However, even if the tax cut expires in 2011, the effect on share prices should be small and the alternatives for minimizing the impact many.

Which leads me to another question I get asked …

“Where Are You Finding the Safest, Richest Dividends Now?”

Three weeks ago, I gave a pretty detailed breakdown of recent dividend trends. If you missed it or want to re-read it, just click here.

But here’s the basic answer: If we’re talking sheer numbers of above-average yields and the highest likelihood for continued dividend increases, I continue to believe the best sectors are consumer staples and utilities. As a bonus, both groups are less economically sensitive, too. However, I have been finding good potential opportunities in nearly every corner of the market — telecom, energy, even technology.

The key right now is paying a fair price. A lot of stocks that I would love to recommend just look a bit expensive at the moment. So I’m keeping them on my watchlist and waiting for pullbacks.

And when I am issuing new buy orders, I’m providing limit orders as insurance against overpaying and getting caught in a “bear trap,” a market rally that ultimately fades.

What about really high yields — ones that exceed 7 percent, 9 percent or even reach double-digits? There are a couple relatively conservative companies I like that are touching those levels at the moment — such as the foreign utility I mentioned last week. But if I had to name one sector that had the largest selection of really big yields right now with some degree of dividend safety, I would point to telecom companies.

And all this talk about sectors leads to one last important question …

“How Important Is Diversification Now?”

After the market action over the last few years, a lot of investors have completely given up on the concept of owning a number of different investments.

But I think they’re wrong. Diversification does still provide additional downside protection and allows your portfolio to continue profiting from different trends as they come and go. Heck, if you have just three dividend stocks as your sole sources of investment income and one of them unexpectedly cuts their payment, you’ll be in a pretty bad spot!

This is why I never make new investment recommendations in a vacuum — instead, I always look at how each position relates to other existing holdings, both in terms of purpose and size.

If you’re building your own portfolio, the same basic idea holds true: Try to hold companies that operate in a number of different sectors and industries … pick some smaller firms and some larger ones … and consider some foreign investments, too.

And even though there’s a lot to love about dividend stocks right now, always mix in some bonds and other types of investments, too.

Best wishes,

Nilus

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