Taxing Choices for Investors
U.S. News and World Report, May 3, 2004, Leonard Wiener
Constant changes make planning a portfolio more difficult
You've heard it many times: The tax tail shouldn't wag the investment dog. But when the tail is fluffy and ill-defined like that of a bichon frise, it is hard to know what to do. Still, shifting tax rates and election-year sparring over economic policy make that investment truism more valid than ever.
Part of the quandary is that the massive tax cuts since 2001--including a reduced bite on income, a phaseout of the estate tax, and minimized taxation of dividends and capital gains--will generally expire after 2008 and 2010. President Bush and his supporters in Congress want to make the changes permanent; Sen. John Kerry, the presumed Democratic presidential nominee, and his supporters, along with others in Congress, want to scale back or redesign many of the breaks.
Throw in a federal budget deficit that is gobbling revenue, and it is no wonder there is unprecedented confusion. "I can't recall when something like this happened before, when so many major elements of the tax structure could sunset," says Lindy Paull, a partner at accountants PricewaterhouseCoopers and former chief of staff of Congress's Joint Committee on Taxation.
Many advisers suggest looking beyond the turmoil to focus on long-term fundamentals. Dividend-paying stocks, for example, have long been favorites of New Orleans investment adviser Fred Siegel. Now that those payouts are taxed at a maximum of only 15 percent, he says, the stocks are more attractive than ever.
Though it may be too conservative for some, Siegel suggests holding 50 to 70 percent of a stock portfolio in firms with a record of annual dividend increases. Growing payouts from this approach can result in a rising yield on your initial investment. Even if tax is increased on dividends, the payouts "put a safety net under the price of a stock," he says.
Though long-term capital gains are now taxed at 15 percent or less, some old ideas remain valid. It can still pay to time trades to offset gains with losses, says Warren Olsen, chief investment officer at the newly formed First Western Trust Bank in Denver. And, as always, "the soundness of an investment, not tax, should drive decisions," he adds.
But today's lower tax rates may make a sound investment move even more attractive. An aversion to paying any tax at all can cause some to miss what may be a once-in-a-lifetime chance, says Charlotte, N.C., advisor Bill Staton. "Tax rates are not likely to get any lower, so this is a good time to take profits, diversify a portfolio, and generally clean house." He says investors sometimes ride a stock up and then down because a phobia of incurring a tax immobilizes them.
Time to switch. Some people may want to seek out a tax liability while rates are low, says adviser Seth Pearson in Dennis, Mass. People with money in a traditional individual retirement account might shift those assets into a Roth IRA, paying tax now on the transferred money but getting tax-free withdrawals of principal and earnings from the Roth in the future. "There may be no better time than now to do that," he says. Though a switch generally isn't allowed when gross income on a return tops $ 100,000, Pearson says many retirees with large assets but modest income might squeeze under the cap, especially if they can delay some of their income.
A federal bite that is becoming more burdensome is the alternative minimum tax, a separately figured levy that can be trouble for some investors in municipal bonds and for employees who exercise stock options. That's because interest from certain tax-exempt "private activity" bonds, which fund such things as housing or student loans, is not exempt from the amt, and employees who escape immediate regular income tax on options may have to pay the amt.
The tax was supposed to ensure that upper-income people with tricky deductions and other breaks pay at least a minimum amount of tax. But if it isn't changed, a fifth of all taxpayers and 40 percent of married couples--many with rather ordinary financial affairs--could be hit by 2010, warns the Congressional Budget Office. Though often unavoidable, the amt may for now be moderated in some cases by timing when to receive income or claim deductions.
People intent on avoiding tax for as long as possible on U.S. savings bonds, meanwhile, face a new deadline. After August 31 they will no longer be able to roll over maturing E or EE bonds into special HH bonds to further defer tax on the bonds' accumulated interest. So anyone considering this may have to act sooner than planned. Though HH bonds pay only 1.5 percent interest, they can be used to soften a big tax hit from e or EE redemptions, notes analyst William Massey at RIA, a publisher of tax guides.
The easing of the estate tax, meanwhile, has planners and heir-conscious investors on edge because few analysts expect the levy to vanish. For 2004, estates of up to $ 1.5 million are exempt from the death levy, a figure scheduled to reach $ 3.5 million by 2009.
But planning is iffy since what lies beyond is up in the air, though many planners expect a permanent exemption at roughly that amount. Lessened tax is removing what for some is a cover story. "Estate planning is often more about controlling who gets what and protecting heirs than about saving tax," says First Western's Olsen.
Whatever the issue, getting your ducks in order requires flexibility. "You can plan for the future but only based on what you know today," counsels Mary-Jo Jacobin of AXA Advisors in New York. "The laws change, the tax rates change, but you can't predict what they will be."
This is an opportune tax time for investors, whether or not you agree with current policy, says Christopher Bergin, chief executive of Tax Analysts, a research and news organization. A political change could turn things around, but at least for now, Bergin believes fundamental changes are taking place. "There is a shift away from taxing investments and savings," he says. "If that's all you worry about, then this is all very favorable."
