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Should I buy dividend funds?
Think twice before trying to get out in front of the Bush tax plan.
January 27, 2003: 2:00 PM EST
By Walter Updegrave, CNN/Money Contributing Columnist

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NEW YORK (CNN/Money) - Since dividends will not be taxed under the Bush tax proposal, I'm interested in finding some no-load mutual funds that pay a good dividend yield. Any ideas?

—Tom Gates, Stockton, Calif.

Yes, my first idea is that you don't start changing your investing strategy because of this or any other of the tax proposals that are floating around out there.

First of all, this is only a proposal, not a new tax law. This baby has got to wend its way through both houses of Congress and then come back to the president to be signed into law. Given the way the Democrats and the Republicans like to play inside the Beltway, this proposal can be shaken, stirred, and turned upside down, inside out or even scuttled entirely.

But even if the proposal does make it to law (or some form that gives at least some break in the tax on dividends), you still can't assume that the best way to capitalize on it is to simply go out and buy dividend-paying stocks or funds.

For one thing, not all dividends will be tax-free to shareholders. Only those that meet the Treasury's definition of "excludable" dividends will qualify. Basically, that means the dividend is tax-free only if it's paid from corporate income that's already been taxed, which isn't always the case.

There's another aspect of the proposal that I'm not sure many investors understand. And that's the provision regarding "deemed dividends." Let's say a company has $2.50 per share in after-tax income that could be distributed as a tax-free dividend. Under the Bush proposal, the company could opt instead to hold onto that money. Even though you don't get a check, you would get a "deemed dividend," which you could add to the cost basis of your shares.

If you sell immediately after getting the deemed dividend, you would erase $2.50 from any profit you earned, thus eliminating taxes on that amount and putting you in essentially the same position if as if you had gotten the tax-free dividend.

This deemed dividend twist means that you don't have to necessarily invest in companies that pay a dividend to get a tax-free return. You just have to invest in profitable companies that pay taxes, because they're the ones that will have the after-tax earnings to generate either cash or deemed dividends.

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One final note: There seems to be this idea among investors that if this proposal passes, we all just invest or money in dividend-paying stocks and funds and that will assure us the highest after-tax rate of return. Sorry, but the financial markets don't work quite that simply. Any edge that dividend-paying or any other type of stock might hold at any time will change constantly as money flows in and out of various types of stocks and other assets. So you can't just assume that a certain type of investment is automatically the best deal.

All that said, I have no problem with someone like you investing in stocks or funds that pay dividends. All in all, I think a greater focus on dividends will be healthy because they're harder to fake than regular earnings. Just don't overdo it. You can screen for dividend-paying funds by going to our Fund Screener.

In addition to looking for such things as consistently good performance vs. similar funds and a return that's commensurate to the risks the fund takes, there's one other factor I'd particularly home in on: low annual expenses. Fund operating expenses are deducted directly from any income the fund collects, including dividends. So to the extent you can find a fund with below-average expenses, you stand a better chance of increasing the dividends that are passed on to you.


Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.