In an era of very low interest rates and unpredictable equities, nearly any solid ground is welcome. Yet pouring your “safe” money into any single-asset income class, even income dividend stocks, is a significant risk.
Sometimes, the risk is obvious. Dividend stocks can fall in value, wiping out gains from dividend payments and appreciation in one blow. If the dividends are rigorously reinvested at lower entry points, that’s some protection. But it’s little help for those who need income to live and cannot reinvest so easily.
Another risk, perhaps less obvious, is the impact of taxes. As the year winds to an end, Congress seems poised to let the country slide off the so-called “fiscal cliff” of billions in tax increases and simultaneous automatic spending cuts.
One of the impacts will be a dizzying rise in dividend taxes. Currently at 15 percent, the rate by 2013 could be as high as the regular income rate — well north of 43 percent for high earners.
A defense to consider is moving a portion of your dividend stock allocation to master limited partnerships (MLPs), particularly if you expect to let this money build over a long period of time and possibly be left to heirs.
The reason why is taxes. MLPs are similar to real estate investment trusts (REITs), except instead of apartments and shopping malls, MLPs deal in energy storage and transport — typically gas pipelines. They can pay higher distributions yet are generally lower risk than many dividend payers.
When you buy a normal dividend stock, the dividend payment flows from earnings every quarter. A long-standing complaint about dividends, however, is double taxation: The company pays corporate taxes on earnings once, then you pay dividend taxes on the earnings again in the year you collect.
With MLPs, you get paid distributions (not dividends) periodically in the same way, but a large part of that cash flow is considered a return of your initial investment. As such, you are shielded from income tax today.
This is tax-deferral, not tax avoidance: Once you sell the position, expect to be taxed at the (probably lower) capital gains rate.
As you collect distributions, too, your cost basis declines. This slowly increases your potentially taxable gain, but you get the income tax break in the intervening time period.
Moreover, tax advisers contend that the cost basis under current IRS code would be recalculated upon death at fair value, reducing the taxable gain in benefit to your heirs. Caution: Taxes issues are complex, particularly at the state level. An MLP strategy is best undertaken with guidance from a tax professional.
Most MLPs yield between 6 percent and 8 percent range, according to a Morningstar analysis.
“In fact, we're particularly fond of pipeline MLPs, which have ample growth opportunities thanks to shifting sources of supplies of crude oil and natural gas,” Morningstar experts contend.
“However, unlike other energy companies, MLPs tend not to take on commodity exposures, reducing risk and cash flow volatility. With distributions typically yielding 6 percent to 8 percent (and growing by 5 percent to 10 percent annually) and offering the opportunity for capital gains, MLPs could provide a compelling total return to investors.”
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