How to Play the Tax Plan

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The President's proposal to eliminate double taxation on stock dividends is a magnum opus of confusion. Want proof? It took Wall Street nearly a week to grasp one of the plan's most fundamental notions: shareholders would be no better off tax-wise with companies that pay a dividend than with those that do not. Still sinking in: dividend investors might even be hurt in the short run because the Bush plan makes it silly to own such stocks in tax-favored accounts, where most people invest.

The smart move has long been to hold high-yielding stocks or stock funds in an IRA or 401(k) in order to shield dividends from income tax. But the Bush plan would penalize investors for continuing to do so. How? When you take a distribution from your IRA, you pay income tax on the entire amount. So any dividends paid into an IRA would ultimately become taxable. Yet in a taxable account, dividends would be tax free. Got that? Well there's more, and it makes a mockery of the notion that tax reform makes things simpler.

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The good news is that stocks would generally receive a lasting boost. Cutting the tax ensures better after-tax returns. So if you've been afraid to step back into the market, get over it. This plan would deleverage corporate America by making stock, not debt, a more attractive way to raise money and restore investor confidence by drawing attention to companies fit enough to boost cash payouts. The plan also encourages companies to stop dodging taxes, because only fully taxed profits could be paid as taxfree dividends. Some form of dividend-tax relief will almost surely survive any political horse trading. Here's a guide to investment winners and losers:

Winners. Even before the proposed plan, more companies were raising or starting to distribute dividends, and those firms were outperforming the overall market. Those trends would continue for years, as soon-to-retire baby boomers focused on the certainty of cash income over the promise of capital gains — as long as both are on equal tax footing. But there are complications. Last year 34 companies in the S&P 500, including Ford and Goodyear, paid a dividend though they lost money and paid no tax. Under the Bush plan, their dividends would be taxable. And 28 other companies, including Kodak and Chubb, paid more in dividends than the company earned. Their dividends would be partly taxable.

You want to focus on companies with steady profits that are already paying a dividend. "They have the ability to keep paying and raising their dividend and have demonstrated the willingness," says Deborah Kuenstner, head of value investing at Putnam Investments. Her picks include power companies Entergy and Florida Power, oil company ExxonMobil and consumer-products maker Procter & Gamble. Other analysts like drugs (Pfizer, Wyeth), financials (AIG FleetBoston) and phones (Verizon, SBC). Proven funds that target dividends: T. Rowe Price Dividend Growth and Capital Income Builder.

Winners. Even if they never get religion on traditional dividends, cash cows Oracle, Dell, Microsoft and Cisco could issue "deemed" dividends that reflect profit that might have been paid as cash but was instead retained by the company for future investment. For tax purposes, the value of undistributed profit would be added to the price you paid for the stock and leave you with a smaller taxable gain when you sell.

Losers. Young companies that don't make a profit can't use the deemed dividend or pay a tax-free dividend. Dump them.

Traditional preferreds would win big. With tax-free yields of 7% or so, they would be a bargain. But more common hybrid preferreds, which pay higher yields, would remain taxable. As with most bonds, stick them in an IRA.

Both losers. Why buy a municipal bond when you can get a higher yield and only modestly more risk with a tax-free preferred stock? REIT dividends would remain taxable. They make sense only in an IRA.