It goes without saying that investors love the tax treatment dividends have enjoyed under the soon-to-expire Bush-era tax cuts. But face it: With Congressional Democrats and Republicans locked in mortal combat in an election year, those sweet tax breaks are as good as gone. Still, buying the right ETFs — at the right time — makes sense even for a post-Taxmageddon portfolio.
First, the bad news. Current tax breaks, which were extended once in 2010, cap taxes on dividends at only 15%, but those provisions expire at year-end. Tax-writing committees on Capitol Hill held a rare joint hearing on capital gains and dividend taxes Thursday, but if they don’t cut a deal by Dec. 31, dividends will be taxed as regular income after Jan. 1, 2013. That means investors in the highest income bracket could face a maximum rate of more than 43% next year.
Now the good news. Dividends have a pretty good track record of weathering negative tax changes. According to Ned Davis Research, S&P 500 stocks that pay a dividend posted an annualized return of 8.7% over the past 40 years, compared to an annual rate of just 1.5% by non-dividend-paying stocks over the same time frame.
And investing in companies that pay consistent dividends makes sense even if taxes do rise. Besides, few investors really would be subject to that top tax rate, and with dividends in tax-deferred accounts, taxes are paid only on withdrawals.
Although the most reliable dividend stocks likely will survive the fallout from losing the Bush-era tax breaks, exchange-traded funds provide another good way to mitigate risk by investing in a basket of dividend-paying assets that trade over an exchange like stocks.
Given the broad menu of dividend-paying ETFs available, a winning Taxmageddon-proof dividend investing strategy also is a matter of making the right choices at the right time. Here are four ETF trading ideas that still look hot:
1. Munibond ETFs for the tax benefits. If you’re in a position to take a big hit from the risk of higher dividend taxes, gaining or increasing a position in a municipal bond-focused ETF can help mitigate that risk. Although yields are sinking, munibonds are tax-free at the federal level, providing some protection from tax changes — particularly for investors in the upper brackets.
If you’re really worried about defaults, consider the iShares S&P National AMT-Free Muni Bond ETF (NYSE:MUB), which is big, broadly diversified and sports a low expense ratio of only 0.25. With $3.1 billion in assets, MUB’s general obligation and revenue bond holdings offer wide geographic exposure including California, New York, Texas, Puerto Rico, Illinois and South Carolina. MUB has a current dividend yield of 4.9%.
2. Large-cap growth funds. If Congress does nothing and the Bush-era cuts expire, dividends will be taxed at a higher rate than capital gains, which will be capped at 20%. That may give companies an incentive to reward shareholders with growth-oriented investments, stock buybacks and stronger balance sheets instead of with increasing dividends.
Top holdings of the iShares Russell Top 200 Growth Index (NYSE:IWY) include solid portfolio picks like Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), IBM (NUSE:IBM), Google (NASDAQ:GOOG), Coca Cola (NYSE:KO), Phillip Morris (NYSE:PM), Verizon (NYSE:VZ) and PepsiCo (NYSE:PEP). With nearly $362 million in assets, IWY’s current dividend yield is a subdued 1.4%, but the ETF has an expense ratio of just 0.2 and a year-to-date return of nearly 20%.
3. Run for cover with an intermediate-term Treasury ETF. For the truly risk-averse investor who’s peering over the fiscal cliff with trepidation, there’s no shame in seeking safety over yield right now. Regardless of what lawmakers do by year-end, an economic slowdown — if not a slip into recession — is likely in 2013.
Treasury yields will probably rebound in response to the Federal Reserve’s latest quantative easing plans, so padding your portfolio with bonds that mature in the three- to 10-year range could be a good option. Consider the Vanguard Intermediate-Term Government Bond ETF (NYSE:VGIT), which tracks the Barclays US 3-10 Year Government Float Adjusted Bond Index. With $285.3 million in assets, VGIT has an expense ratio of just 0.14 and a current yield of 1.6%.
4. March may be a good time to buy utility ETFs. Utility stocks have been dividend superheroes, compensating for lower growth with stable income. But faced with low interest rates and stingy bond yields, investors have flocked to utility stocks, which now sport premium valuations. And the rapid run-up in share prices has left these traditionally dull darlings looking a lot like speculative bets.
But if dividend taxes do rise, expect the bloom to come off these roses. Historically, dividend-paying stocks have lagged the broader market for about six months after a tax hike, with the worst fallout coming in the first three months.
If that happens, you may be able to buy into the Utilities Select Sector SPDR (NYSE:XLU) at a bargain. With $6.1 billion in assets, XLU’s top holdings include dividend champions like Duke Energy (NYSE:DUK), Southern Co. (NYSE:SO), Exelon (NYSE:EXC), Dominion Resources (NYSE:D) and NextEra Energy (NYSE:NEE). With an expense ratio of 0.19, XLU has a current dividend yield of 3.8%.
As of this writing, Susan J. Aluise did not hold a position in any of the aforenamed securities.