Many companies in the S&P 500 index are flush with cash as they economy starts to make a comeback and retail customers return to stores. In fact, the S&P 500 companies have over $800 billion in cash and cash equivalents on their books, and the number continues to grow as companies focus on cost-cutting measures, free cash flow, and protecting themselves from more market turmoil. There is so much cash on the balance sheets of companies that many financial analysts think that investors may see a resurgence of special one-time dividends. But, investors should beware of companies issuing these special dividends. While they may sound great in theory, they may not be the greatest thing for investors.

Special Dividends Dont Offer an Arbitrage Opportunity

It does no good for an investor to chase special or even regular dividends when deciding when to purchase shares of stock. Many investors think they can buy a stock and hold it through the ex-dividend date (the date at which you must be the owner of the stock to qualify for the dividend) and then sell the stock the next day. The problem with this strategy is that the stock price will drop by the dividend amount that next day because the company will have lost value due to the reduction in its cash balance. Thus, what you gain in the dividend payout you lose in the reduction of the companys stock price. So, for example, a company that trades at $20 per share and issues a one-time special dividend of $2 should be worth a price of $18 on the day after the ex-dividend date.

Special Dividends Are A Sign Of Lack Of Creativity

A special dividend signals to investors that the company cannot think of anything better to do with its available cash. For example, there may be no other profitable opportunities to grow the business, and that is why the cash as been piling up. This is exactly what happened to Microsoft a few years ago when it issued a special one time dividend and investors responded with a negative reaction. It is also similar to what investors are currently seeing in big technology companies like Google today who are slowing down and acquiring less companies because theyve hit a growth peak.

Taxes On Dividends Are Set To Change

Currently, dividends are taxed at their lowest level in a very long time. Dividend income is only taxed at the 15% rate. But, that benefit is set to expire at the end of 2010 year unless it is extended by Congress, which seems unlikely. Future tax rates on dividend income could be considered ordinary income which means that dividend income could soar as high as almost 40% for the top income earners.

Final Thoughts

While there is room for stock dividends in every investors portfolio, you need to be aware of some of the risks. Dividends often show that a company is out of ideas and may represent a poor use of company funds. Also, when considering investing in a company that has announced a special dividend (or any dividend for that matter), remember that there is no free money to be had in the investment. The market is too efficient to allow for any kind of arbitrage opportunity. Lastly, the tax consequences can be huge for dividends.

What are your thoughts on one-time special dividends?