Hedging Your Bets on the Tax Cut

Long-term planning is complicated by the possibility that the changes will end in 2008. Still, there are some strategies that can pay off

By David Wyss

President Bush's $350 billion tax-cut package signed into law on May 28 creates befuddlement as well as opportunity for the individual investor. Financial planners and accountants are still sorting out how the new law will affect taxpayers. And economists are parsing what impact the changes will have on investing behavior and economic growth, which remains sluggish. But it's not too early for investors to begin their own investigation of how the tax-law changes might affect their portfolios and investing strategies.

The lower capital gains rate (15% from 20%) and much lower dividend rate (15% from 38.6%) suggest that portfolios should be shifted more to stocks. Indeed, some of this may already be happening, as the major market indices closed higher for six of the past seven trading sessions.

Just as important, the new law reduces the benefits of tax deferment in traditional retirement saving 401(k) and IRA accounts. But complicating the outlook for investors is the fact that the tax breaks are scheduled to end after 2007. If that happens -- and there's a great deal of debate in Washington and on Wall Street about whether it will -- investors should proceed judiciously in planning to shift their asset allocation. Here are some things to consider in that process:

AIMING HIGHER.

  For taxable accounts, investors should probably include more high-dividend stocks. There's no question that if the law were permanent, this would be a good move. As it is, the question of how far the portfolio should be slanted depends on whether you believe the dividend provisions will expire, or "sunset," in five years.

If you load up on high-dividend stocks and Congress allows the dividend rate to go back to the ordinary income rate in 2008, as the legislation states, you would be joining other investors in selling off those stocks at fire-sale prices. My advice would be to shift your taxable portfolio toward more high-dividend stocks, and cut back on bonds, but don't go hog wild.

And be careful which high-dividend stocks you add. Not all dividends will be taxed at the 15% rate. In particular, stocks and mutual funds that are simply a pass-through of income, such as real-estate investment trusts (REITs), still will be subject to ordinary tax rates. Most foreign corporations' dividends also will be subject to full tax rates. Until the Internal Revenue Service writes the final regulations, these would be a gray area to avoid.

GAIN SAYINGS.

  Stocks will benefit from capital-gains as well as dividend changes. If the tax law change were permanent, the price of common stocks should rise an average of 5% (or 46 points on the S&P 500 stock-index from its May 27 close of 951), with high-dividend stocks rising somewhat more. My personal guess is that dividends will be treated the same as capital gains even after 2008, but it's clearly uncertain. Stocks will thus rise somewhat less than 5% on average. If we assume 50% odds, the S&P 500 should rise 23 points, or about what it has gone up since the compromise on the tax bill was reached.

Take your losses, but let the gains run at least a year to get the lower tax rate. The lower rate increases the importance of holding assets until you can claim capital gains. It also increases the advantage of mutual funds that trade less frequently, such as index funds, since almost all their capital gains are long term.

Dividends aren't likely to increase much, since the sunset provision gives chief financial officers a clear motive not to change dividend policy significantly. If the tax breaks are temporary, there's little reason for corporations to pay higher dividends, especially if executives feel the market will punish the stock if dividends are cut in 2008. More closely-held corporations are more likely to increase dividends, especially if the change is temporary, because this would be a one-time opportunity to distribute low tax income to the owners. By David Wyss

RETIREMENT PLANS.

  IRA and 401(k) plans should still be fully funded. The lower capital-gains rate reduces, but doesn't eliminate, the advantage of tax-deferred income plans. If an investor has $5,000 in pre-tax income to invest and is 10 years from retirement, a traditional IRA or 401(k) is still the best alternative. If we assume a conservative 8% return, the $5,000 will grow to $10,800 at retirement in 2013. Afterwards, the retiree can withdraw $800 per year ($512 after taxes) without going into principal, still leaving $10,800 ten years later.

On the other hand, because the initial $5,000 contribution is not tax-deductible in a Roth IRA, an investor in the top bracket would invest only $3,400 after taxes and have $6,900 at retirement. To have the same after-tax "income" of $512 a year would keep the account stable at $6,900 in 2023. Putting the same money in a taxable account, with the same after-tax withdrawals, would result in an estate of only $4,900 in 2023.

Increasing the time-to-retirement to 20 years only slightly changes the calculation. Note that under current tax law, the after-tax income could be only $488, and the estates would be $10,800 in the IRA, $6,600 in the Roth, and $3,900 in the taxable account in 2023. The calculations ignore estate tax -- or assume that the elimination of the tax in 2010 also refuses to sunset in 2011, as currently scheduled.

WAIT FOR NEXT YEAR.

  An IRA or 401(k) thus remains the preferred saving instrument for Americans in higher tax brackets. The advantage is even more pronounced if investors expect to drop into lower tax brackets when they retire. But it's less clear if retirees expect taxes to rise in the future. In either case, however, the Roth IRA still does better than a taxable account, although not as much better than before the new bill was signed into law.

From a macro perspective, most of the short-term stimulus in the bill comes from the lower taxes paid as a result of moving forward the 2001 tax cuts. The dividend and capital-gains cuts have an equivalent impact, but the cash will not be seen by taxpayers until next April 15. And the wealth effect (from the higher value of stocks) takes about a year to be reflected in consumer spending.

Thus the biggest impact of the dividend and capital-gains proposals will be in 2004, not in 2003. The combined impact of all the tax changes should add about a percentage point to the economy's growth rates from the fourth quarter of 2003 through 2004.

THE REAL NUMBERS.

  Investors may feel like celebrating, but it's also wise to remember that the tax bill is much bigger than the headlines suggest. The current bill is as big as the President's proposal -- at least if the provisions don't sunset in 2008. The true 10-year cost is over $700 billion. The released figure has been held down because Congress only calculated tax losses until 2008, when the bill sunsets.

The $700 billion tax cut will push the federal budget deficit higher which will mean higher bond yields over the long haul. The new rates provide some clear short-term opportunities for stock investors, but easy-does-it likely should be the reaction to this tax cut package.

Wyss is chief economist for Standard & Poor's

Edited by Karyn McCormack

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