Tax rates on corporate payouts are heading higher for some. Don’t just sit there.

The budget deal that emerged in Washington earlier this month provided good news and bad regarding tax rates on dividends, a primary source of income in later life for many retirees.

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The basics: Qualified dividends, as well as capital gains, for individuals in the 25%, 28%, 33% and 35% income-tax brackets will continue to be taxed at 15%. Individuals with more than $400,000 in taxable income—and couples with more than $450,000—will see the rate rise to 20%. (People in the 10% and 15% brackets, as before, will have a zero tax rate on dividends and capital gains.)

Of course, these figures are just a start. We asked Charles Farrell, chief executive of Northstar Investment Advisors LLC in Denver and author of Your Money Ratios, to survey the new dividend landscape. Here are excerpts of that conversation.

WSJ: How would you evaluate the new tax package in terms of dividends?

MR. FARRELL: From an investment standpoint, the deal is pretty good, considering the range of alternatives.

In particular, tax rates for dividends and capital gains were consistent. If one was favored over the other, then you would likely get a distortion of how money is allocated based on tax rates, which usually isn’t a good approach. For instance, you could have investors favoring non-income-producing assets if dividends were taxed higher, or vice versa if capital gains were taxed higher.

ENLARGE

Phil Foster

WSJ: What are the downsides?

MR. FARRELL: Taxes on dividends will still rise for individuals with incomes above $200,000 and families above $250,000 because of the new Medicare tax.

This 3.8% tax applies to net investment returns. It’s technical, but it basically covers income from capital gains, interest, certain annuities and dividends, plus a few other things. So, many families will pay a total of 18.8% (15% plus 3.8%), plus whatever their state taxes are. For the highest wage earners, the tax on dividends is 23.8% (20% plus 3.8%).

WSJ: How big of a role do dividends play in the markets and in people’s investments?

MR. FARRELL: About 80% of the companies in the S&P 500 pay dividends. These include some of the largest companies in the country: Exxon, IBM. Apple, Chevron and Procter & Gamble. among others.

Dividends are crucial to long-term returns. If we look back at the past 100 years in the stock market, dividends account for about 50% of investors’ total return. The other 50% is from price appreciation, or capital gains.

So if you cut dividends out of your portfolio, your expected return goes from the historical average of about 9.5% to around 4.75% to 5%, and you eliminate 80% of the stocks you could own.

ENLARGE

WSJ: What steps can investors take to minimize the effects of higher taxes on dividends?

MR. FARRELL: The best way to combat that and keep more money is to have the dividends grow.

Let’s say income-tax rates go up. You don’t go to your boss and say: Cut my pay from $60,000 to $30,000 because income-tax rates have gone up. Rather, your reaction should be: I need to make more money to offset these taxes. With dividends, it’s the growth in payouts that fights inflation, fights taxes and helps pull along stock values.

Take a company whose stock is valued at $100 a share and that pays a $5 dividend per share, for a yield of 5%. That’s an attractive yield. But let’s assume the company doesn’t raise the dividend. If your tax rate jumps from 15% to almost 24%, your after-tax dividend income return drops from $4.25 to about $3.80. With no prospects for dividend growth, this is a real cut to your return.

But let’s assume you anticipate dividend growth of 5% per year. That means the $5 dividend per share would grow to a little more than $8 per share after 10 years. Well, if your tax rate is almost 24%, then your net after-tax dividend would be about $6, which is more than the $4.25 after-tax return you were getting when the tax rate was 15%.

WSJ: If the best way to fight higher tax rates on dividends is dividend growth, should investors simply buy and hold stocks with proven track records of annual increases in dividends?

MR. FARRELL: That’s a prudent strategy—but you want to be sure you are adequately diversified so that your equity income stream is coming from all corners of the economy.

Let’s look at 2008. While banks had a good history of raising dividends, they got into trouble and had to cut them. It would have been a good idea, for instance, to have had some utilities that continued to pay their dividends, even though they weren’t growing much.

WSJ: Should we take any lessons from the new tax package?

MR. FARRELL: Before year’s end, there seemed to be plenty of people discussing dumping dividend stocks and trying to guess which way rates were going. If investors reacted to that, as I expect many did, then they would have most likely harmed themselves.

It’s just a good lesson in investment and tax planning. Don’t try to predict political decisions—which taxes are. Make the prudent investment decision, and then try to manage the tax issues to the extent they impact you.

Mr. Ruffenach is a reporter and editor in The Wall Street Journal’s Atlanta bureau and the editor of Encore. He can be reached at encore@wsj.com .