WASHINGTON, May 29 (UPI) -- The tax bill signed by President George W. Bush Wednesday has a number of positive features, notably the modest Keynesian stimulus to the economy it gives from the child credit expansion and the pulling forward of top tax rate reductions from future years. But the dividend and capital gains tax provisions are a mess, and make investment planning for the ordinary saver much more difficult.
For a start, you need to rethink which investments go into your retirement savings plans and which you should buy directly. Traditionally, advisers have insisted that as much as possible should be held in tax-deferred form, where earnings accumulate tax free. However, after the passage of this bill, the decision about where to put your money is more complicated. If you put it into a tax deferred fund, for example, you will pay tax at your marginal income tax rate on withdrawals, but save only 15 percent tax on dividends and capital gains.
Of course, tax deferral can benefit you, but it can take an awfully long time to do so. For example, if you have the choice between investing in a stock or a growth mutual fund, (the latter linked to an index so it does not "churn" its investments) with a 1 percent dividend yield, the tax-deferred plan will eventually come out better -- but only after 207 years. For the first couple of centuries, holding the stock or fund in a taxable plan will be clearly superior.
That's true only for those plans in which the only major tax advantage is deferral of tax until the money is withdrawn, such as Individual Retirement Accounts where the contributions are not tax-deductible. In the case of traditional IRAs, you have an additional advantage in the deductibility of the up-front contribution. Since this enables you to gross up your saving by your top marginal income tax rate, putting money into a traditional IRA is still a good deal.
Section 529 educational savings plans and Roth IRAs are also a good deal, because the money is not taxed at all when it is withdrawn, so there is no withdrawal tax penalty at your full marginal rate offsetting the savings in 15 percent tax on capital gains and dividends. These are still a good deal, therefore.
If you have both tax-deferred and taxable savings, and engage in "asset allocation" between bonds and stocks, the best plan is to put bonds, and stocks you may want to sell quickly into the tax deferred fund, and index mutual funds and stocks for long-term investment into the taxable fund. That way, you avoid the risk of incurring short-term capital gains (still taxed at full income tax rates) in your taxable fund, but instead have only dividends and long-term gains there. Bond interest, still taxed at full income rates, is then in the tax-deferred fund.
There is however another snag, which is the Alternative Minimum Tax, that with this tax bill imposes an alternative tax rate of 21 percent on all income above $58,000 for a married couple (the threshold is currently scheduled to drop back to $40,000 in 2005.) If you are a wealthy retiree, with say $100,000 of dividend income and $200,000 of long term capital gains, and maybe $30,000 of home mortgage and medical deductions, the chances are that under the existing tax law, your tax rate would have been above the AMT threshold -- probably taxes of around $60,000, with a top marginal rate of 31 percent on the dividends and 20 percent on the capital gains.
If you are planning to go on a really big vacation with your savings from the new law, don't. While theoretically, you ought to save $10,000 on the capital gains and around $10,000 on the dividends, reducing your tax to $40,000, this won't happen, because of the AMT. With say $7,000 of AMT personal allowances, your AMT tax will be 21 percent x $235,000, or $49,350. Still a worthwhile saving, but only half what you thought you'd get. And in 2005, when the AMT threshold reduces to $40,000, your tax liability will increase by another $3,780. What's more, it's two federal tax returns each year for you from now on!
The AMT glitch points up one huge disadvantage of the tax cut: it almost all reverses itself in a few years' time. On dividends, the tax cut expires in 2009. Of course, Republican leaders express their determination to extend the cuts when the time comes, but ask yourself this question: are you absolutely SURE that the federal budget deficit won't be a huge problem in 2004, when the AMT exemption needs to be raised, or in 2008, when the dividend tax needs to be renewed?
I'm not. In fact, in line with my general bearishness, what I think Congress has done is to lock in a series of tax increases, starting in 2005 and extending through 2011 (when the estate tax and income tax rates revert to their levels before the 2001 tax legislation.) Some of the 2001 and 2003 tax cuts will be extended of course, but were I William Bennett I would bet heavily that the price of getting any such extension through Congress, will be swingeing tax increases in other areas.
That, after all, was the purpose of the 1990 Byrd Amendment, sponsored by pork-barrel king Sen. Robert Byrd, D-W.Va. In Byrd's world, tax cuts, the cost of which must be multiplied over 10 years, are always temporary and reversible, whereas spending increases, once legislated and accounted for only once, are built into future budgets and become untouchable.
Congress has messed up your investment portfolio, and it's probably not worth the brokerage costs of reorganizing it extensively to fit Congress's wishes, since the changes are undoubtedly temporary.
And do NOT warrant a further run-up in the already overvalued stock market!
(Wing Collar is a biweekly column of personal finance advice, expected to appear alternate Thursdays. It intends to give readers the solid financial advice, tailored for today's financial needs and markets, that a wing-collared bank manager would have given in the days before bank managers were salesmen.)
