The news around dividend-paying stocks became the focus of conversation at the start of the year with BP's massive oil spill into the Gulf of Mexico. When the events began to unfold, BP suspended its dividend to prepare itself for the costs associated with cleaning up the largest environmental disaster in U.S. history. With such events, investors were suddenly reminded of how important it is to maintain a diversified investment portfolio.

Needless to say, BP and the group of stocks that belong to the same category as a whole are generally viewed as a hedge against market volatility. Dividend-paying stocks are generally seen as high-quality companies with large cash flows and solid balance sheets. At a time where yields are scarce on fixed-income instruments such as short-term bonds which have plummeted below 1%, dividend stocks can potentially provide investors an alternate source of a liquid source of income.

It's a common misconception that dividend-paying stocks are above all best suited for conservative investors or those that are approaching retirement. In fact, dividend-payers use some of the income they might otherwise use to fuel growth to reward their shareholders. These companies have the potential to pay investors in two ways: through capital appreciation albeit at lower rates and through yield.

Over many years, this double return or in essence a double dividend can have a significant effect on a portfolio. As a matter of fact, in the past several decades, dividend-paying stocks in the S&P 500 have outperformed S&P non-dividend-paying stocks by an average annual rate of return of 1.48%. Furthermore, Nasdaq, the place where many high-growth tech stocks are traded, has underperformed the S&P Utilities Index, which is composed of conservative dividend-paying stocks. This goes to show that compounded over many years, the combination of the dividend yield and rates of return attributed to appreciation can be substantial as a matter of total return of a portfolio.

Will higher taxes offset the benefits?

Dividend-paying stocks took a turn for the worst in the recent market downturn. In 2008 and 2009, in an effort to clean up their balance sheets, companies began cutting their dividends across the board. As the economy improves, however, more companies will use the excess cash to increase their dividends to attract investors seeking yields.

Unfortunately, the greatest threat to dividend-payers may not be the recent market down or the disaster of the spill in the Gulf, but the new wave of tax changes surrounding dividends. In 2003, President Bush lowered the tax on qualified dividends to the rate of the capital gains tax of 15%. However, as the Bush tax cuts are set to sunset in 2010, qualified dividends are set to be taxed again at higher ordinary income tax rates. With ordinary income tax rates set to rise to 39.6% for the highest earners and to 44% when the new health care surcharge takes effect in 2013, that would translate to almost a three-fold increase in the dividend tax rate.

Although the White House has alluded to reducing the qualified dividend tax rate to 20%, at which point dividend-paying stocks could still maintain their favorable tax advantages over other types of investments, there is no guarantee of that happening. If the White House decides otherwise, consider reallocating funds from high-quality dividend-paying companies to shares in high-quality and high-yielding master limited partnerships (MLPs) to reap the same if not better tax treatment. Typically invested in the energy infrastructure sector and listed on the same exchanges as the dividend-payers, MLPs enjoy different tax treatments from corporations. Mainly, MLPs allow shareholders to treat portions of their dividend income as a return on capital with the taxes not due until the asset is sold.

There are many factors that contribute to MLPs' appeal to investors. Yields have been increasing in this sector as of late that are even higher than those of comparable dividend-paying stocks. For example, share prices of the Energy MLP Index are up around 10% for the year so far.

Understanding yield

When analysts and companies refer to yield, they are not making a reference to a stock's dividend but to its dividend yield (dividend divided by the stock's share price). High yield doesn't necessarily translate to high quality investments. Higher yields can happen when a stock's share price has sunk as a result of a company's troubles. However, when combined with strong fundamentals, a high-yield may mean that the stock is undervauled for the time being but has the potential to appreciate while the investor gets paid a nice dividend to wait.

It is critical to make that differentiation when choosing dividend-paying stocks for your portfolio. Pay attention to the overall strength of the company and the reasons behind the increase or decrease in dividend payouts. Your Financial Advisor can help you screen for high-quality companies with strong underlying fundamentals and good dividend-yields.