The new tax law is changing the way Georgina and I invest our money.
Yes, I know that tax considerations should not drive investment decisions. You should pick an investment because it is a good one, not because of the tax benefit. What matters is not paying less in taxes, but getting the most after-tax return.
That’s the standard advice from financial professionals, and it is good. But how you get the most after-tax return may have changed significantly with a cut in the long-term capital gains tax, part of the Taxpayer Relief Act.
Lowering the tax from a maximum of 28 percent to 20 percent makes a true and universal distinction between tax rates for “ordinary income” and long-term capital gains.
Besides wages, ordinary income includes interest from bonds and bank accounts and dividend payments from stocks and mutual funds. Long-term capital gains are defined now as the profits from the sale of assets such as stocks, bonds and mutual funds held for at least 18 months.
According to the Internal Revenue Service, 95 percent of American taxpayers paid the same tax rate on capital gains as we did on ordinary income.
Now all of us will pay a lower rate for long-term capital gains than for interest and dividends or even for money we take out of tax-deferred retirement accounts, such as regulars IRAs, 401(k) plans and annuities. Those withdrawals are taxed as ordinary income, even if the accounts grew in value as the result of capital gains.
For taxpayers in the 15 percent tax bracket–those with taxable income up to $41,200 for married couples filing jointly and $24,650 for singles–the tax on long-term capital gains is now 10 percent, or only two-thirds of the tax paid on ordinary income.
For those in the 28 percent tax bracket (up to $99,600 in taxable income for couples and $59,750 for singles), the capital-gains tax is 20 percent, or about 71 percent of the rate on ordinary income. The capital-gains rate is also 20 percent for taxpayers in the three top brackets–32, 36 and 39.6 percent.
“Investments that yield ordinary income may no longer be as desirable when weighed against investment opportunities that produce capital gains,” said Mark Luscombe, federal tax analyst for CCH Inc., a leading tax publisher in Riverwoods.
Some caveats, though. Investments that seek capital gains, such as stocks, tend to be riskier. Also, to plan properly, you have to make at least an educated guess of the tax bracket you will be in when the tax is finally due on your growth investments.
But that said, the changes in the law may call for a revised strategy.
“You shouldn’t let taxes have an undue influence over your investment decisions, but when the landscape changes like this, you have to carefully think this through,” said Steve Norwitz, a vice president of T. Rowe Price and principal author of the retirement kits put out by the mutual fund company.
Georgina and I have thought it through and come to these conclusions:
For the portion of our money we want to keep in growth investments, as much as possible will go to taxable accounts. Should we have to sell at a loss, we can still deduct up to $3,000 of net losses against ordinary income, whereas a loss in a tax-deferred plan gives you no tax benefit at all.
Tax-deferred accounts will work better for us holding high-yield investments, such as bonds, that would have generated ordinary income.
For investments earmarked for the long term–which I define as five years or more, preferably at least 10–individual stocks are much more attractive than stock mutual funds.
As long as you don’t sell a stock, you don’t owe any taxes on the gains, and when you finally sell, you will be taxed at a lower rate than ordinary income.
With mutual funds, you are at the mercy of fund managers who often replace all the stocks in the portfolio at an average of once a year. This leads to short-term capital gain distributions that are taxed as ordinary income to you, even if you don’t sell your shares. (Ironic, isn’t it, that the same manager who urges you to invest in his fund for the long term is forever turning over his portfolio?)
Variable annuities have lost much of their luster. Georgina and I are not adding a penny to ours, both because of the impact of the new tax law and the fact we may want to start taking money out in seven or eight years.
Annuities charge higher expenses than similar taxable investments, but the tax-deferral is supposed to make up for that after 10 years or so. But how good is tax deferral if you owe higher taxes at the end?
Tax-deferred accounts that provide other benefits are worth keeping, and adding to. For example, regular IRAs that give you a tax deduction upfront or the new Roth IRAs that will allow tax-free withdrawals at retirement or 401(k) plans that lower your taxes now and often come with matching contributions from your employer.
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Humberto Cruz welcomes questions and comments from readers. Although he cannot respond to each one individually, he will answer questions of general interest in his column. Write to him c/o Tribune Media Services, 435 N. Michigan Ave., Suite 1400, Chicago, Ill. 60611. Send e-mail messages to: HCruz5040aol.com.
