The Advocate and Greenwich Time, Sunday, June 15, 2003

Rethinking Investment Choices Under the New Tax Act

Julie Jason

You are probably wondering whether you need to change your investment decisions because of new reduced taxes on corporate dividend distributions.

As we discussed last week, the Jobs and Growth Tax Relief Reconciliation Act of 2003, which was signed into law May 28, lowers taxes on corporate dividends received in 2003 through 2008. The act also lowers long-term capital gains to a maximum of 15 percent (5 percent for taxpayers in lower tax brackets) for stock sales after May 5.

Here is a ranking of income-producing investments based strictly on the effect of taxes, prepared with the help of tax experts Evan Snapper of Ernst & Young and William Philbrick of Greenberg, Rosenblatt, Kull & Bitsoli PC of Worcester, Mass.

The list is in the order of best tax efficiency to worst. The ranking will not tell you which investments you should buy, since that decision is not based solely on taxes. As the saying goes, "Don’t let the tail wag the dog."

As you are considering the list, think about whether you should hold some of your less-tax-efficient investments (ranking 4 or below) in a tax-deferred account, such as an individual retirement account, instead of a taxable account.

1.Tax-free municipal bonds: When the new tax act was proposed, income taxes on corporate dividends were to be completely eliminated, which would have made dividend-paying stocks not only the most tax-efficient, but also potentially more desirable to investors than municipal bonds. Since Congress reduced, but did not eliminate income taxes on dividends, municipal bonds remain the most tax-efficient income-producing investment.
2. Income-producing investments held in Roth Individual Retirement Account: You can withdraw dividends and interest (and principal and gains) from a Roth IRA completely free of federal and state income taxes, assuming you are over 59½ and have held your Roth for more than five years.

Because you can invest stocks and bonds in a Roth IRA, you might rank a Roth as the best all-round investment vehicle for flexibility and tax efficiency. It is ranked second here only because of tax penalties for early withdrawal (before age 59½) and the five-year holding period. 
3. Dividend-paying stocks: Dividends paid by domestic stocks or stock mutual funds investing in domestic stocks are now taxed at a rate of 5 percent or 15 percent, depending on your tax bracket.

4. Government bonds and government bond mutual funds and unit trusts: Interest from U.S. government and agency bonds, notes and bills is taxed at ordinary income tax rates. 

Government bond interest is exempt from state income taxes. Dividends paid by bond mutual funds are taxed at ordinary income-tax rates.

If your ordinary income-tax rate is higher than 15 percent (or 5 percent), then the top three choices on this list will be more tax-efficient for you than the rest. 

Who falls into that category? If you are single and you make more than $28,400, married filing jointly making more than $56,800, or filing as a head of household and making more than $38,500, your ordinary income tax rate will be higher than 15 percent – as high as 35 percent for the top bracket. 

5. All the instruments whose distributions are taxed at ordinary income tax rates on both the federal and state tax levels: These are savings accounts, bank certificates of deposit, corporate bonds and corporate bond mutual funds and unit trusts, immediate and tax-deferred annuities, and tax-deferred accounts such as traditional IRAs, 401(k)s and the like.

Note that some annuity and traditional IRA distributions or withdrawals may not be fully taxable. For example, there is an adjustment for nondeductible IRA contributions or a return of principal used to purchase a nonqualified annuity.

Capital Gains Taxes

In addition to taxes on distributions such as interest and dividends, you also have to consider whether there is a tax on the sales of the asset.

If you sell a stock or a municipal, government, or corporate bond at a profit, the gain will be taxed at the new long-term capital gains tax rate of 5 percent or 15 percent. 

To qualify for the lower rate, you must have owned the instrument for more than one year and the sale must occur after May 5. You may offset losses against gains as before, and losses can be carried forward. The $3,000 annual limit for deducting losses against income has not changed. 

If you withdraw money from a savings account, certificate of deposit, an annuity or tax-deferred account such as a traditional IRA or 401(k), profits or gains are not distinguished from other withdrawals and are taxed at ordinary income-tax rates.

However, withdrawals from annuities may include a return of principal, which would not be taxed. Traditional IRAs may also have been funded with nondeductible monies, which will reduce the amount that is subject to tax.

Watch out for penalties when you take out money from certificates of deposits and annuities. 

Be sure to talk to your tax adviser before making any decisions to realign your investments based on the new tax law.

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Julie Jason encourages readers to send in their 401(k) questions and stories for discussion in the column. Email Julie Jason atJulie.Jason@snet.net or write: Julie Jason, The Advocate and Greenwich Time, PO Box 9307, Stamford, CT 06904. Jason, a money manager who has a juris doctor and master of laws degrees, is the author of "Strategic Investing After 50" (John Wiley & Sons, 2001), "You and Your 401(k): How to Manage Your 401(k) for Maximum Returns" (Simon & Schuster, 1996) and "The 401(k) Plan Handbook" (Prentice Hall, 1997). She is managing director of Jackson, Grant Investment Advisers, Inc. of Stamford.