Apple's (AAPL) dividend announcement this past week is good news for income investors, but bad news might be lurking around the corner.
Unless Congress takes action, the top tax rate for the highest earners on most dividends, currently 15%, is set to jump to a whopping 43.4% next year. That is a maximum income-tax rate of 39.6%—since dividends will once again be taxed as regular income—plus a 3.8% tax on investment income as part of the health-care overhaul passed in 2009.
Higher dividend taxes could take some luster off dividend-paying stocks—and because the market is forward-looking, the fear is that their prices will fall sooner rather than later.
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Dividend investors could protect themselves in the short term by placing options bets on a broad decline in dividend-paying shares, but that strategy is expensive. A better course for most is to seek a balance of income and growth stocks. In the income-stock portion, investors should favor those that promise to boost their dividend payments over those that merely have the largest "dividend yields," or payments as a percentage of their stock prices.
Apple's new dividend payments of $2.65 each quarter, set to begin July 1, give it a yield of 1.8%, calculated against its current stock price.
Apple is hardly alone in bowing to growing investor demand for yield. Last year brought a record 22 dividend initiations by companies in the Standard & Poor's 500-stock index. There have been five so far in 2012.
There is plenty of room for more and bigger payments. While 397 S&P 500 companies pay dividends, the average since 1980 is 413 companies. And payments as a percentage of profits are only 30% now, versus a historical average of 52%, according to S&P.
All told, dividend spending by S&P 500 companies should increase 15% this year, estimates Howard Silverblatt, senior index analyst at S&P.
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Of course, dividends are only as valuable to investors as the portion left after taxes. The current 15% rate cap comes from a 2003 series of temporary rate reductions that were extended through 2012. On Jan. 1, the rate cap expires, unless Congress acts.
No one knows how the politics will unfold. Jeremy Zirin, chief equity strategist at UBS (UBS), guesses—and it is only a guess—that politicians will settle for "the path of least resistance" with another short-term extension of the cuts sometime after the election.
For purposes of planning and prudence, investors should assume higher dividend taxes are coming and focus on the likely fallout. History offers some useful clues.
Companies increased their dividend payments substantially after the 2003 tax cut, but lower taxes weren't necessarily the cause. A 2010 study done for the Federal Reserve Board found that higher profits were the likelier driver. A case in point: Real-estate investment trusts, whose generous dividends don't qualify for the current lower rates, also increased their payments.
The findings suggest the dividend floodgates won't necessarily slam shut in response to higher taxes come 2013 or beyond.
Investors also should remember that a dividend-tax rise concentrated on high earners would affect only a small percentage of the population, while a large portion of dividend stocks are held in pensions and other tax-deferred accounts. That should damp the effect of tax increases on the broader market, says Jim Russell, chief equity strategist at U.S. Bank.
An analysis by Savita Subramanian, head of U.S. equity at Bank of America Merrill Lynch, found "no evidence that the change in the dividend-tax rate had any significant impact on the relative performance of dividend-oriented strategies." Ms. Subramanian found that dividend growth matters much more than tax-rate changes in determining future stock prices.
Dividend investors might thus want to sell shares of some high-yielding companies that aren't boosting their payments and add some with moderate yields and steady payment growth.
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One easy way is to buy a mutual fund focused on companies with growing dividends, such as T. Rowe Price Dividend Growth or Vanguard Dividend Growth . The T. Rowe Price fund ranks among the top one-quarter of its peers for 10-year performance. The Vanguard fund ranks among the top one-tenth.
UBS's Mr. Zirin says investors who have too much money in the utility and telecom sectors, which investors tend to seek out for high yields, might want to diversify into consumer staples and industrials, which have lower yields but stronger growth characteristics. Exchange-traded funds like iShares Dow Jones U.S. Industrial Sector (IYJ) and Consumer Staples SPDR (XLP) can offer quick sector diversification.
Joel Dickson, head of Vanguard Group's active quantitative equity department, says focusing exclusively on dividend stocks is a mistake, because it can leave investors overexposed to large-company value stocks. That was fine last year when the Dow Jones U.S. Select Dividend Index returned 12.4%, versus a 2.1% return for the S&P 500. But so far this year, the dividend index has underperformed.
With or without the threat of a dividend-tax increase, investors with a dividend-heavy portfolio should consider balancing their approach by adding something as simple as a broad-market index fund, Mr. Dickson says.
Vanguard Total Stock Market, Schwab U.S. Broad Market (SCHB) and iShares S&P 1500 (ISI) are low-fee choices. And unlike next year's tax rates, next year's fees are something investors can control.
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