Sherrill St. Germain
This article was originally published
in “Insight,” the
newsletter of Lumbard
Investment Counseling of Hollis, NH.
With the passage of the new tax law on May 28, investors
have been asking: “How do I take best advantage of
the tax cuts to help me reach my retirement, college funding,
and other goals?”
First, the facts:
- The tax rate on long-term capital gains has been
reduced from 20% to 15% for taxpayers in the top 4 brackets.
It is just 5% (0% in 2008!) for those in the two lowest brackets.
Note: These rates do not apply to gains on the sale of collectibles,
or to unrecaptured Section 1250 gain.
- For taxpayers who favor dividend-paying stocks
(other than REITs and some foreign companies), the news is
even better. Previously taxed as ordinary income (maximum
rate 35%), dividends on shares meeting the required holding
period are now taxed at long-term capital gains rates.
- The rates expire in 2008 unless Congress extends them.
So should investors abandon 401Ks, IRAs, 529s, etc., in
favor of less restrictive taxable accounts, now that the
cost of doing so is substantially lower? It depends. Investors
close to retirement might be better off paying 15% on earnings
from taxable accounts now (vs. up to 35% on retirement plan
distributions a few years out) and preserving the option
to harvest capital losses. For younger investors, especially
those with employer matching, the benefits of tax deferral
over many years should more than compensate for higher rates
at distribution time.
With their federal and (usually) state income tax-free treatment
of earnings and high contribution limits, Section 529 plans
remain an important college savings vehicle. For more flexibility
of investment choices and use of the money, use a Roth IRA
as well, if eligible. Also, if you’ll be selling assets
to pay college bills, consider gifting the assets to a child
who qualifies for the 5% capital gains rate. (Watch gift
tax and college financial aid eligibility!) With rates unlikely
to ever be lower, this might be a great time to sell long-held
No matter what choices you make, you’ll want to place “tax-inefficient” investments
such as REITS and high-yield bonds into tax-advantaged accounts.
Assets which qualify for the lower rates (such as common
stocks) should be held in taxable accounts.
With all of its nuances, limitations, and interdependencies,
income tax planning is usually best addressed on a case-by-case
basis. Today, the difficulties are magnified by the enormous
uncertainty about future tax rates; 5 years from now, 10
years from now, and far beyond. As with investing, a bit
of diversification – i.e. using a combination of tax-advantaged
and taxable accounts – can mitigate the impact of an
unfavorable tax change.
With apologies to Ben Franklin, nothing is certain except
death and taxes… and, as recent history has shown,
changes to the tax code.