By now you've no doubt read or heard about the $350 billion tax package just signed into law by President Bush. As you'd expect, the provisions grabbing the headlines focus on tax cuts. Tax rates affecting everything from individuals to stock dividends are heading lower.
However, beyond the short-term excitement over the prospect of lower taxes, there are important long-term implications for investors. For instance, if the interest paid by bonds is going to be taxed at ordinary income tax rates as high as 35% while dividends paid by stocks will be taxed at 15%, should you shift your bond holdings to your tax-sheltered account and hold stocks in a taxable account?
Let me warn you ahead of time so you're not disappointed: I don't have all the answers. That's because it's impossible to predict the future -- in particular, what personal income tax rates will be. Do you think they'll remain where they are? Or are they likely to head higher? Lower? Your outlook on this issue has a direct impact on the conclusion you reach. Yet who can predict this? So much depends upon which party controls Congress and the White House.
The economy is another wild card. Do you believe the recovery will be robust, lackluster, short-term? Your outlook affects everything from inflation and interest rates to the size of the federal deficit and stock market returns.
Tax regulations are another moving target. Some parts of this latest tax act expire in a few years, which makes long-term planning especially challenging.
That said, uncertainty has always been a part of investing. The best you can do is make educated assumptions, accepting the fact that you'll have to adjust your portfolio periodically as the landscape and your own personal circumstances change.
As long-time readers of this column know, I'm a big believer in not setting out on this journey alone. It's important to have an experienced financial advisor as a partner -- someone who can help you see the big picture, nudge you to take important, but sometimes uncomfortable paths, guide you through the changing regulatory landscape, and be a sounding-board, especially during difficult markets such as we've experienced in the past three years,.
With that in mind, I tapped several respected experts for their input on what the individual investor ought to consider in the wake of this important tax legislation.
I urge you not to rush to make wholesale changes to your portfolio based on what their comments. Instead, use them as a starting point for a discussion with your own financial advisor, focusing on your specific situation.
Keep in mind that while taxes are an important factor for an investor to consider, they should only be a secondary consideration. Despite the new, favorable tax treatment of dividend-paying stocks, it would be ludicrous to have all your money in this single asset class. If we learned nothing else from recent market history, it should be the importance of being broadly diversified and owning a balanced portfolio that spans multiple investment categories and styles. First and foremost, your portfolio should be built around your investment goals and the time frame you have for achieving them -- not the tax treatment of specific investments.
So let's dig into this tax package by highlighting the changes that will have the bigget impact on individuals. Because Congress and the President are hoping to give the economy an immediate boost by putting more money into the hands and wallets of consumers as quickly as possible, many of the changes this tax act ushers in take effect right away.
A retroactive cut in income tax rates. (You remember that retroactive increase we got a few years ago under another president, don't you?) Instead of waiting for lower rates to be phased-in over several years as outlined in the Economic Growth and Tax Relief Reconciliation Act of 2001, the reductions in individual income tax rates get accelerated into 2003.
As of January 1st of this year:
instead of this tax rate: 38.6% you'll pay this tax rate: 35%
If you work, you'll get your first taste of these lower tax rates in July. That's when lower withholding taxes take effect. As a result, your take-home pay will increase slightly. Mark Luscombe, principal tax analyst for CCH, a major provider of tax information, says the new withholding rates don't account for the higher rates we will have paid for the first half of this year; you'll get that money back when you file your 2003 income tax return. But Luscombe says, based on the new, lower rates, "people who pay estimated taxes on a quarterly basis may have overpaid their taxes for the first quarter. They should make an adjustment to their next payment due by June 16."
In addition, one aspect of the marriage penalty which is particularly painful for two-income couples, is eliminated: the 15% tax bracket has been widened so that it is twice as large for couples who file jointly as it is for a single taxpayer. John Fenton, a staff writer for the National Underwriter Company says this will provide real relief, "especially where both spouses make comparable salaries."
Some two million taxpayers who are subject to the Alternative Minimum Tax (AMT) get some -- temporary -- relief. The exemption for married couples who file jointly increases from $49,000 to $58,000; for single taxpayers it increases from $35,750 to $40,250. While this is a bigger increase than included in the 2001 Tax Act, CCH's Luscombe says the impact of this change will just be to "keep additional people from falling under the AMT and won't affect the long-term trend."
That trend means more and more middle income Americans are getting stuck with a tax that -- decades ago -- was specifically aimed at the "wealthy." However, because the income levels for the AMT are never adjusted for inflation, as salaries have increased over the years, so have the number of individuals hit by this tax, which can be as high as 28% on ALL income above the exemption amount.
The Treasury Department estimates the AMT will snare 40 million taxpayers by 2013 unless changes are made, but Luscombe isn't hopeful of a permanent fix because that would be "pretty expensive." So these temporary adjustments are likely to continue for the foreseeable future. The higher exemption levels in this tax package are only good for 2003 and 2004. After that, who knows?
The other major change affects families with children. The child tax credit jumps from $600 to $1,000 per child -- but only for this year and 2004. Based on their 2002 tax returns, most taxpayers who were eligible for this tax credit last year, can expect to get a check in the mail for as much as $400 per child by late July or early August. Low-income taxpayers who didnt get the credit in 2002 because they paid little or no income tax will not be getting a check. If, because of your income, you only qualified for a partial credit last year, you'll get a portion of the $400. This is simply an advance against your 2003 taxes. If it turns out you don't qualify this year, you'll have to pay it back when your taxes are computed.
Fenton, who contributes to the tax publications National Underwriter puts out, has a personal interest in this part of the legislation: he has a 6-month old baby. He says there is no limit on the number of children for which you can claim the credit. However, they must be under the age of 17. This means if you qualified for the credit last year because your son was 16 years old, don't expect a check in the mail this year. The I.R.S. is going to screen for this.
In addition, not every family is eligible for the credit because, as mentioned, it gets phased out based on your income. You lose $50 of the credit for every $1,000 (or fraction thereof) in adjusted gross income you have above the following limits:
Single taxpayer: $75,000
Married, filing jointly: $110,000
But Fenton points out that that because the child credit is so much larger this year, your income can hit a higher level before you lose the credit completely. So people who didn't qualify for any credit at all in previous years might now be eligible for at least a partial break.
"Growth and income investments will be especially helped by the tax cuts," say Alan Skrainka, Chief Market Strategist for the St. Louis-based brokerage firm Edward Jones. He's referring, of course, to the reduced rates for both stock dividends and longterm capital gains. Under this legislation, both are pegged at 15% -- and both are slated to return to their previous levels at the end of 2008. (Taxpayers in the two lowest brackets would pay 5% in both cases.) Considering that, up to now, stock dividends have been taxed at ordinary income tax rates as high as 38.6%, the new rate represents a potential tax savings of 60%!
According to Skrainka, "We've always liked companies that not only pay dividends, but increase them consistently. 44 out of 47 of the stocks in our recommended portfolio pay dividends and more than half have increased their dividends for the past 15 years." These include household names such as Johnson & Johnson, Pepsico, Wells Fargo, and Walgreens.
Richard Whitley, a top-producing advisor for H.D. Vest, says unless clients have about $100,000 to invest so they can be broadly diversified across a number of industries, he's recomending they avoid individual stocks and stick to "professionally managed accounts such as mutual funds." He points out that "it doesn't matter to an individual if their dividend is taxed at 15% of their principal is demolished."
He likes the diversification that mutual funds provide, adding "instead of one stock, you own dozens through a mutual fund, so the impact of any problems with a single security is diminished." To take advantage of the new tax rates, consider general dividend-paying stock funds as well as those that invest in specific industries that historically have had regular dividends, such as utilities or financial companies.
In the long run, Whitley believes the greatest impact of the reduced rate on stock dividends will be indirect, by encouraging more companies to pay dividends. "Once a company pays a dividend it doesn't want to reduce it.
It wants to maintain or increase it." As a result, profits must become more predictable. "The more predictable the earnings of a company, the more stable its stock price. The more stability we have in the stock market, the faster investors will return."
While National Underwriter's Fenton believes the new 15% rate on dividends and long-term capital gains "changes the equation" in terms of which investments belong in tax-deferred retirement accounts versus regular, taxable accounts, Skrainka and Whitley are more cautious. Both acknowledge that the higher tax rate imposed on bond interest, income from real estate investment trusts and preferred stocks, means it might make sense to own a greater portion of these in your tax-sheltered retirement plans, while owning the bulk of your stock investments in your taxable accounts. But neither thinks investors ought to eliminate equities from their retirement plans entirely.
"The importance is to have good balance," says Skrainka. CCH's Mark Luscombe concurs, saying "it doesn't make sense to have only taxable bonds in your retirment account because you want to be diversified."
Do IRAs still make sense? Luscombe says Roths are "still a winner" because contributions can grow tax-free. And provided you qualify for a tax-deductible contribution, a traditional IRA still makes sense. But, he says, non-deductible traditional IRA are a lot less attractive now. "If you're paying a 15% tax on income and gains from dividend-paying stocks, I think it probably makes a lot of sense to NOT contribute to a non-deductible IRA" because you'll get hit with [the much higher] ordinary income tax rates on withdrawals."
For his part, Whitley, a CPA, is still a big believer in tax-defered retirement plans. "The fastest money to make is the money made by saving taxes" by contributing to a company plan. "The majority of my clients are paying a combined federal and state tax rate of 27%-35%. That's how much they save in current income taxes by taking advantage of their employer-sponsored plan."
However, he admits that once you've maxed out your retirement plan contributions, the tax changes have created a "significant advantage" for investments that offer both growth and income. "You get tax-advantaged dividends now and tax-advantaged growth later" when you sell the stocks.
Provided, of course, you do this before the 15% rate expires. Which is one reason Skrainka maintains that "equities still make sense in your retirement account."
Especially when you consider the demographics. "We are a nation that is transitioning from investors wanting capital gains, to people looking for income," says Skrainka, pointing out that baby boomers won't be able to afford retirement if their income is solely dependent on interest income. "You need a rising income stream to overcome inflation. " Historically, the place to get that is from stocks.
So take it slow, my friends. As much as we want a black-white answer, unfortunately, there is no one-size-fits-all prescription that applies to investing. There's also no reason to rush into any wholesale changes in your portfolio. Remember, your time horizon and investment goals come first, and taxes second. Consider getting a second opinion from a professional before you make a move.
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