Dividend Stocks Might Do Fine In 2013 Even If Tax Rates Spike

Higher taxes on dividends could lead investors to dump income stocks — right? Not necessarily, say some strategists.

Depending on how Washington's fiscal cliff maneuvers turn out, the effective dividend tax rate could spike on Jan. 1 from 15% now to 44.6% for investors in the top bracket.

But strategists give several reasons why dividend stocks could continue to show strength in 2013. They include how such equities have previously reacted to tax changes, the effect of tax-advantaged accounts and the lack of alternatives for investors.

Income stocks, using the SPDR S&P Dividend ETF (SDY) as a proxy, have delivered a total five-year return of 5.34% vs. the S&P 500's 2.02%. It's also outperformed on a three-year basis, though it's lagged in 2012, returning 13.01% vs. the S&P 500's 17.37%.

Demand for dividend-paying stocks won't change much in 2013 due to higher taxes, according to Savita Subramanian, head of U.S. equity and quantitative strategy for Bank of America Merrill Lynch. She and her team have studied how dividend stocks performed when tax policy changed or seemed about to change, such as when President George W. Bush cut the dividend tax rate to 15% in 2003, or when the market previously feared a hike in 2010.

"There's not been a particularly strong relationship between the performance or valuation of dividend-yielding stocks and changes in tax rates," she told IBD. That finding is in line with research by other financial firms. There could be a little bit of a sell-off, but it would happen largely in the highest-yielding stocks like utilities, Subramanian said.

Sam Stovall, chief equity strategist for S&P Capital IQ, cites tax-advantaged accounts as a reason why higher taxes on dividends won't scare off many income investors. It's generally estimated that about 50% of dividend-paying stocks are held in such accounts, he said.

"While people might worry about it, the thought is, 'I'm not going to get taxed on it, so maybe I shouldn't worry about it,'" Stovall told IBD.

He also said that history indicates that companies themselves won't dramatically alter their dividend policies. Stovall said: "The analysts that I've spoken with say they've gone through a variety of tax policies from varying administrations, and if a company regards itself as a source of income, it's really not going to deviate from that.

Stovall, Subramanian and other strategists note that income-seeking investors simply have few options in the current low-rate environment.

"Where are they going to go?" she said. "I think this equity yield story continues to be attractive until we see bonds offer competitive yield.

Dividends Not Second-Class

Subramanian adds that in the past few years, the market has seemed more accepting of companies that initiate a payout.

"You might not penalize a company for paying a dividend the way that investors did back when there were more abundant growth opportunities," she said. "Even in the 'growthier' sectors like tech or retail, companies that have initiated dividends have actually been rewarded rather than penalized.

While companies have announced special or accelerated dividends ahead of the fiscal cliff, that won't hurt payouts in 2013 that much, according to Stovall. He cites a forecast from S&P Dow Jones Indices, which says the special or accelerated dividends in Q4 2012 will reduce Q1 2013 payments, but payouts in Q1 2013 still will top those in Q1 2012.

So what dividend stocks look good for 2013

Stovall's picks include Chevron (CVX), Microsoft (MSFT) and UGI (UGI), a utility. He screened for stocks with yields of 3% or more, a track record of increasing their earnings and dividends, and other factors.

Among recent IBD 50 stocks, dividend payers include Eastman Chemical (EMN), Ingredion (INGR), Polaris Industries (PII) and Seagate Technology (STX).