New tax law calls for a portfolio tune-up
Changes favor stocks for taxable accounts, bonds for tax-deferred accounts
Investors are often reminded to review their portfolios regularly to make sure their exposure to stocks and bonds is still appropriate, given changes in market conditions and their personal situations.
Now they have another reason to check their investments: The tax law signed by President Bush last month contains several provisions that could change how people allocate their money among both tax-deferred accounts, such as IRAs and 401(k) plans, and taxable accounts.
The new law cuts the tax on profits from investments held at least a year from 20 percent to 15 percent. This rate applies to sales after May 5, 2003. The tax on most stock dividends also has been cut to 15 percent, retroactive to January 1, 2003. Dividends had been taxed at the investor's ordinary income rate. For investors in the 10 percent and 15 percent tax brackets, the tax on dividends will be just 5 percent.
The law also cut the top four income tax brackets to 25 percent, 28 percent, 33 percent, and 35 percent, effective January 1, 2003. The top brackets had been 27 percent, 30 percent, 35 percent, and 38.6 percent. These reductions were enacted as part of the 2001 tax law, but were not scheduled to be phased in fully until 2006.
Because of these changes, "we think people should consider combining their taxable and tax-deferred accounts into one - at least mentally,'' says Mary Malgoire, a certified financial planner in Bethesda, Md.
Of course, Ms. Malgoire stresses, money cannot be moved from a tax- deferred vehicle into a taxable account without penalties. But investors should view both types of accounts as two parts of an entire personal portfolio.
Under the old rules, it made sense to emphasize stocks and stock mutual funds in IRAs, 401(k) plans, and other tax-advantaged vehicles, in order to defer the tax on dividends and capital gains.
Now, with a 15 percent tax on dividends and long-term capital gains, stocks and stock mutual funds have become more attractive for taxable accounts, since the tax bite is smaller.
Meanwhile, fixed-income investments, such as bond mutual funds, may now play a bigger role in tax-deferred accounts. That's because the interest paid by these securities is still taxed at the investor's regular income tax rate, which can be as high as 35 percent if held in a taxable account.
Also, dividend income from some equity-type investments, such as real estate investment trusts (REITs) and preferred stock, also will be taxed as ordinary income.
None of this means all stock investments should be shifted to taxable accounts and all bond investments should be put in tax-deferred accounts, Malgoire says.
Instead, she is advising clients to think about reorganizing both types of portfolios. For example, if 80 percent of your IRA is in stock funds, you may want to move some money in the IRA to bond funds.
This will not only provide more tax-deferred income, but might help dampen some of stocks' price volatility.
While a 15 percent tax sounds like a good deal, there's a way to reduce it even more, says Beth Gamel, a financial planner in Waltham, Mass.
Parents and grandparents who own stock or stock funds can give those investments to children or grandchildren who are age 14 or older. In most cases, the child's tax on long-term gains will be just 5 percent.
"Let's say you bought a stock several years ago for $1,000 and it's now worth $20,000," Ms. Gamel says. "If the child sells it to pay for college, they'd only have to pay 5 percent tax on the $19,000 profit."
For many investors, the idea of taxable capital gains is moot, Gamel says. The stock market's poor performance until this year has left many people with significant tax losses that they can use to partially offset any gains for the next several years, she explains.
By then, the rules may have changed again: To keep the initial cost of the tax bill close to $350 billion, the law includes a "sunset" provision, which means the reduced tax rates for dividends and capital gains will expire in 2008 and the old, higher rates will return.
On the other hand, a future Congress may make this year's tax cuts permanent, but that's not a sure thing.