Tax law now is favorable
to dividend-paying stocks

Not too long ago, inflation was low enough to spur concerns about the possible effects of deflation. But that was then -- and this is now. Today, we're seeing signs that inflation may be picking up. As a consumer you can adapt your purchasing habits to cope with higher prices. But, as an investor, how should you respond to inflation?

For starters, don't get too alarmed -- we aren't anywhere near the inflationary levels we saw in the late 1970s and early 1980s. Nonetheless, even a gradual increase in inflation may be enough for you to consider making some investment moves. Your fixed-income investments, such as bonds and certificates of deposit, are particularly vulnerable to higher inflation. Consequently you may need to consider investments that offer rising income.

Where can you find such investments? Start by looking at stocks that may pay dividends -- particularly those high-quality stocks that increase their dividend payouts, year after year. Of course, companies that have historically paid and increased their dividends may not always do so, but those businesses with good track records of paying dividends are typically well-run firms, capable of adjusting to different market environments and determined to reward their investors.

Furthermore, from a tax standpoint, it's a good time to invest in dividend-paying stocks. If you're in a tax bracket of 25 percent or higher, you'll only have to pay 15 percent for most types of domestic stock dividends you receive. Before tax laws were revised last year, these dividends would have been taxed at your individual tax rate. (The new rate is scheduled to expire at the end of 2008, after which dividends will again be taxed at your personal tax rate.)

To combat inflation, you don't have to rely solely on stocks that can increase their dividends. Here are a couple of other investment possibilities:

» TIPS. When you invest in Treasury Inflation Protected Securities (TIPS), your return will be linked to inflation -- specifically, the Consumer Price Index for All Urban Consumers. So, if inflation rises 3 percent, the value of a $1,000 TIPS bond also rises by 3 percent, to $1,030. And this type of "indexing" will continue until your TIPS bond matures.

Every six months, the principal value of your TIPS bond will be adjusted for inflation -- and your interest payments are based on that rising principal. However, you will have to pay federal income taxes on this interest and on the inflation adjustment, even though you don't really receive this adjustment until your bond matures. To avoid being taxed annually on this "phantom" income, you may want to put your TIPS in a tax-deferred instrument, such as an IRA.

» REITs. As inflation increases, the value of real estate usually rises as well; as a result, real estate is considered a good hedge against inflation. You might want to consider investing in a real estate investment trust, which buys, operates and sells residential and commercial real estate.

By investing in dividend paying stocks, TIPS and RElTs, you can help your portfolio stay ahead of inflation. But don't forget that inflation is just one factor to evaluate when you're reviewing your holdings. Don't forget about growth, diversification, and tax management -- they're all important elements of successful investing.