Financial Planning for July 2003

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What Do We Do Now?
Life used to be simple. Let’s see, from a tax perspective, long-term capital gains were good, dividends and short-term capital gains were bad, tax-deferred savings were attractive so you maxed out on your retirement accounts then invested in tax deferred annuities after that. Since you had to have a home, mortgage interest deductions were desirable and, since over the long haul the market earned enough to outstrip your mortgage interest by a long shot, you weren’t in a hurry to pay down the mortgage.

With the passage of JGTRRA (the short name for the new 2003 tax act) life has become more complicated – again!

Now that certain dividends and long-term capital gains are taxed at the same 15% rates – even lower for low income taxpayers – the distinction between long-term growth and current cash flow has become quite blurry. As we said in The Road Ahead this month, the increase in the standard deduction for married taxpayers has reduced the tax benefit from itemized deductions, mortgage interest included, so now you have to make the choice between paying off the mortgage or investing in the market…well some people do anyway.

So, the big question is where do you go with your investments now? Our answer, of course, is that depends. It depends on where your portfolio is today and what you are trying to achieve.

Let’s get the easy stuff out of the way first. Some folks are wondering if it still makes sense to max out on their deductible retirement savings like 401(k) plans, Simple plans, IRAs and the like. In a word – yes. But the dividends and capital gains are taxed at the regular rates, not the 15% rates, you may think. You are right, but what you gain in having the up front tax deduction and reinvestment of untaxed income will generally offset any savings from lower tax rates. Not only that, but if your employer matches your contribution, just participating automatically increases your yield.

For example, assume you put 10% of your pre-tax earnings into a 401(k) Plan and you earn $100,000 per year. Your employer matches your contribution dollar for dollar up to a total of 5% of your pre-tax earnings (yes, there are employers who do that). Your contribution will be $10,000 and your employer will put in $5,000. Assuming you’re fully vested and no gain or loss on your account, you already have a 50% return without any risk. Of course, in the real world, there is a risk of loss because of market fluctuations, but hopefully you see what a powerful earnings tool employer matches are.

First, depending on your age, you will be putting off paying income taxes far into the future. It’s likely that by the time you pay those income taxes, you will be in a lower tax bracket than you are now. Second, unless you plan on retiring by the end of 2008, the capital gains revert to their current rate and dividends are taxed the same as ordinary income. Third, there really is no guarantee that Congress won’t change its collective mind if the balance of political power in Washington changes.

Ok, so now you’re convinced to stay in your retirement accounts. You also have a pretty hefty taxable portfolio. What should you invest in to get the most bang for your investment buck? The first thing to remember is Don’t invest just for tax purposes. At the risk of hitting a sore spot, if your primary goal were to invest to save taxes, investing in the next Enron or WorldCom would be your best bet. Luckily, you wouldn’t buy that even if we were selling it. Always invest in what makes economic sense and what makes economic sense is the investment that will give you the best after-tax investment return.
For some, what will make economic sense is to convert the stocks in their retirement accounts into interest producing assets while moving fixed income securities in your taxable account into dividend producing equity investments. It’s better to pay 15% on dividends in your taxable portfolio than the maximum 35% tax you would pay on taxable interest. If you have a gain on those fixed income securities, the next few years may well be the time to take the gains in your taxable account.

There are several things to keep in mind when making the decision. First, whatever you do, make sure you get or remain well diversified. If there is one lesson we should have learned over the last few years, it’s don’t put all your eggs in one basket. Second, if you choose to move to good investments that pay dividends, make sure your dividends will qualify for the 15% rate.

Generally, common stock issued by U.S. corporations will qualify for the 15% rate after you or your mutual fund have held the stock for at least 60 of the 120 days surrounding the "ex-dividend" date of the stock. However, REIT distributions, dividends that are essentially disguised interest payments as is the case with many dividends on preferred stock and dividends paid by certain foreign-based corporations will not qualify for the 15% rate.

Finally, if you have a large amount of investment interest expense, remember that any dividends that qualify for the 15% rate will not be counted as investment income. While you can elect to treat the dividends as ordinary income and count them as investment income, you may harm yourself going strictly for qualifying dividends.

The buzz in some corners of the investment community is that tax-deferred variable annuities ("TDA") now make no economic sense. While it is true there are high surrender charges and large up front costs, for a price, you have the ability to get a guaranteed return regardless of what the market does. You also gain some measure of comfort for your family with the insurance features of the annuities. And as we said, there is no guarantee that the dynamics that put annuities behind the eight-ball will still be in place five years from now.

Typically TDAs are long-term investments, so take a long-term view when making the decision on a variable annuity product. Run the numbers with a long-term horizon, not assuming you will need the money a year from now.

One very valuable planning technique, assuming you expect investments to appreciate, is gifting stock to your children. If you have children at or over 14 years old, gifting appreciating stock could save a great deal. If you have held the stock over a year, your child could sell the stock. If they are in the 15% bracket, they will pay only a 5% tax instead of the 15% you pay. Even better, if they hold it and sell in 2008 and they are still in the 15% or 10% bracket, no tax is paid at all. If the stock pays dividends, it will most likely be taxed at 5% instead of your 15%.

What about all those tax-exempt bonds and funds out there? With such low rates on taxable dividends, isn’t it time to dump them? If you are in a higher bracket, you will still probably benefit from holding tax-exempt securities, so don’t start dumping just yet.

So, is everyone ready to restructure their portfolios? Wait! Hang on a minute. Remember, if you are truly investing and not gambling…errr...speculating, you better not jump too fast. Reviewing your portfolio and determining the tax effects of restructuring is going to be tricky. Now we aren’t saying you don’t have the ability to run the numbers, but just in case you don’t want to go crazy with all the interactive calculations, give us a call. We have the knowledge and the tools to help you make the right decision.

Have a great Independence Day and wonderful July! Don’t forget to keep our troops around the world in your hearts and prayers.


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