Investors who have rushed into dividend ETFs the past two years in search of income need to be mindful that taxes on dividends are scheduled to rise next year if the Bush-era tax cuts are allowed to expire.

However, the chance that investors may end up forking over more dividend income to Uncle Sam doesn’t necessarily mean they should run out and dump their dividend-themed ETFs, which have been hot sellers in a low-interest-rate market for bonds.

“The appeal of dividends is not now–and has never been–purely a function of tax policy. Dividends work because they deliver what capital gains can’t: consistent cash returns that are always and only positive,” says Josh Peters, editor of Morningstar’s Dividend Investor newsletter.

“Rather than depending on fickle and often panicky markets for returns, dividends provide cash flow that you can use to meet your personal investment objectives even if stock prices are down,” he writes. “And, compared with bonds, dividend-paying stocks offer a measure of protection from inflation and a good shot at lasting capital appreciation.”

In other words, taxes are part of the return equation but investors need to take a broad view on dividend ETFs.

President Barack Obama’s re-election and the looming fiscal cliff have many predicting that the tax breaks on stock dividends and capital gains won’t be renewed at the end of 2012. If the tax cuts expire, the rate on qualified dividends could rise from 15% to as high as 39.6% for top earners. [Dividend ETFs: What Obama Win Means for Tax Rates]

Dividend ETFs vulnerable?

Some have even speculated the prospect of higher tax rates on dividends has driven the market lower the past few weeks as investors sell stocks before year-end. However, the argument is “difficult to square with history,” writes Mark Hulbert at MarketWatch. “There is no apparent correlation between past changes in the dividend tax and the stock market’s performance.”

“Many investors are particularly worried that dividend stocks are vulnerable given the potential for a near tripling of the tax on dividends,” adds Russ Koesterich, chief investment strategist at ETF manager BlackRock (NYSE: BLK).

Yet he doesn’t think dividend stocks overall are any more exposed than the broader market. He cites three factors: many dividend stocks are held in non-taxable accounts, companies have historically made investors whole on an after-tax basis by raising their dividends to offset the higher tax rate, and many high dividend payers are concentrated in defensive sectors that fare better in a weak economy. [Three Reasons Not to Flee Dividend ETFs]

Morningstar’s Peters points out that it’s not a given that dividend taxes will rise. “That outcome can’t be ruled out, but it’s worth remembering that in 2003, 2008, and again in 2010, a span encompassing three different congresses and two presidents of differing political affiliations, the current taxation of dividends has been affirmed,” he writes.

“Even if taxes on dividends go up, we have to ask ourselves what the alternatives are. Except for municipal bonds, the interest (however paltry!) paid on fixed-income securities is already taxed as ordinary income. Bolting for the bond market would only reduce your tax bill to the extent you earned much smaller returns!” Peters says.

Some of the largest dividend ETFs for U.S. stocks include Vanguard Dividend Appreciation (NYSEArca: VIG), iShares Dow Jones Select Dividend Index Fund (NYSEArca: DVY), iShares High Dividend Equity Fund (NYSEArca: HDV), SPDR S&P Dividend ETF (NYSEArca: SDY), Vanguard High Dividend Yield Index Fund (NYSEArca: VYM), WisdomTree Dividend Top 100 Fund (NYSEArca: DTN) and First Trust Morningstar Dividend Leaders (NYSEArca: FDL). [Dividend ETFs Under the Microscope]

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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