Should Tax Changes Mean Investment Changes?

Whatever happened to the concept of tax simplification?

The federal tax law changes passed by Congress last week are laudable in many respects, but they also make investing, saving and estate planning more complicated for nearly everyone.

Steve Forbes and the flat tax idea--your country needs you now!

On the assumption that Steve is out of commission at least until the next presidential election, however, it’s left for individual Americans to translate these latest tax changes and make the most of them.

Many people will face a host of decisions: Which individual retirement account will be best, the new one or the old one? Should stock mutual funds and other potential capital-gain-generating investments be held in tax-deferred retirement accounts such as 401(k) plans, or outside them? Is it worth holding securities for at least 18 months to take advantage of the new, lowered capital gains tax rate?

It would be easier for everyone, of course, if there were simple, one-size-fits-all answers to those questions. Unfortunately, there aren’t. The right answers will depend on your age, your family status, your income, your assets and, perhaps most vexing of all, the guesses you will have to make regarding future tax law and your investment returns.

Even so, there is some general advice that most people can follow in evaluating their options and opportunities under the new law.

Here’s a look at some of the key points to consider:

* Younger people should stay in tax-deferred retirement plans. Because the maximum tax on long-term capital gains (such as stock appreciation) has been cut to 20% from 28%, many investors will naturally wonder if they are saving for retirement in the right method.

That’s because the money you’ll eventually pull out of an IRA or Keogh retirement plan, or from tax-deferred retirement savings plans such as employer-sponsored 401(k) and 403(b) plans, will be taxed at whatever your ordinary income tax rate will be at retirement.

At current tax rates, you might expect to give up 28% to 31% in federal tax on the money you remove at retirement. (If you’re really wealthy, you’ll pay 39.6%.)

By contrast, with an investment that is held outside a tax-deferred account and which generates a long-term capital gain, that gain would be taxed at the new, low 20% rate when you sell--or at an even better 10% for people in the lowest tax brackets (i.e., joint filers with incomes under $41,200 in 1998).

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Time to junk your 401(k) plan? Not so fast. Assuming the choice is between owning a stock mutual fund within a 401(k) or as a normal investment, remember that mutual funds must pay out realized long-term gains each year.

In a tax-deferred account, those gains are reinvested and left to grow, and you don’t incur a tax bill each year. In a normal fund account, gains also may be reinvested (most people do), but you still will owe taxes each year on the gains received.

The bottom line: The longer you have until retirement, the greater the power of compounding within a tax-deferred account.

A study by mutual fund firm T. Rowe Price shows that a $10,000 investment that earns 13.7% a year over the next 20 years (that was the average return over the last 20 years for growth-and-income stock funds) would be worth $83,429 at the end of the period, assuming it was in a normal taxable account and the investor’s tax bracket was 28% for ordinary income and 20% for long-term capital gains.

That same investment in a tax-deferred account, meanwhile, would be worth about $132,000 at the end of 20 years--about $48,600 more than an account that was paying taxes all along.

True, you’d just begin to pay taxes on the tax-deferred account at that point. But remember the time value of money--and also that your larger nest egg at that point would be generating larger continuing returns than a smaller already-taxed account.

And we haven’t even discussed the ongoing tax savings you enjoy as your 401(k) contributions reduce taxable income. Plus, if your employer matches your contributions, that’s free money.

Add it all up, and for most people in their 20s, 30s and even 40s, “it’s still hard for me to say they shouldn’t defer [taxes] on everything they can,” said John Markese, president of the American Assn. of Individual Investors in Chicago.

* Older people should think about accumulating more assets outside tax-deferred plans. The closer you are to retirement, the more it may make sense for you to begin buying and holding investments without the benefit of tax shelter.

The tax changes detailed above are one reason: If you’re going to be paying a 36% or 39.6% tax rate on money you pull out of a retirement account in a few years, while long-term capital gains are taxed at just 20%, the numbers may heavily favor the non-tax-deferred account.

“For my clients, who are high-net-worth individuals closer to retirement, the issues [with regard to tax deferral] are going to be different” than for younger people, said Deena Katz, head of Coral Gables, Fla.-based financial planning firm Evensky, Brown, Katz & Levitt.

And even for people in the same basic age range (say, 55), she notes that the factors involved (tax rates, income, time until retirement) will vary for each individual, and thus the decisions on where best to hold assets will differ.

Michael Lipper, head of mutual fund tracker Lipper Analytical Services in New York, notes that there are many reasons why investors would want to hold an increasing share of their assets outside retirement accounts as they age.

For one, he said, you may want greater flexibility to offset investment gains with investment losses--and losses inside retirement accounts do you no good for tax purposes.

Second, if you want to make a gift of appreciated assets to charities for write-off purposes, you would need those assets free of retirement-account encumbrances.

Lipper uses a housing analogy to make a case for account-type-diversification: As you get older and, it’s hoped, wealthier, “you would probably have a [larger] home with more specialized rooms,” he said. “The same should be true of your portfolio.”

All that said, the new Roth IRA created by the tax law (named for Sen. William V. Roth Jr. [R-Del.]) may be of great interest to investors of all ages. It will allow couples earning up to $150,000 and singles earning up to $95,000 to set aside up to $2,000 a year per person--and never pay tax on any of the investment returns generated by that money, when eventually withdrawn in retirement (subject to certain restrictions).

* All investors should weigh the benefits of using a regular investment program versus just winging it. And by that we mean: Before you consider abandoning or cutting back on a regular and automatic investment plan such as a 401(k) or 403(b) in favor of making individual investments, think about what you might lose in terms of discipline.

The real beauty of an automatic investment program is precisely that--you don’t have to think about it. That means investments are made without being affected by any emotions generated by short-term market swings.

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“That structure is extremely important to most people” in the long run, said Markese of the AAII. Left to their own devices, many people probably would never invest; they would wait for “a good time to get into stocks,” for example, but the time would never seem quite right, for whatever reason or reasons.

* Remember that this won’t be the last change to tax laws. It was probably Will Rogers who said that while the only two sure things in life are death and taxes, death doesn’t get any worse every time Congress meets.

For planning purposes today, you will have to assume that current tax rates on ordinary income and on capital gains will be the same in 10, 20 or 30 years, when you’re ready to retire. But Congress is sure to change tax rates over time, as it always has.

That’s why the most important thing you can do is simply to build a high-quality, well-diversified portfolio, and invest as much as you can early in life. Tax considerations should always take a back seat to that primary concern.