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RETIREMENT PLANS. IRA and 401(k) plans should still be fully funded. The lower capital-gains rate reduces, but doesn't eliminate, the advantage of tax-deferred income plans. If an investor has $5,000 in pre-tax income to invest and is 10 years from retirement, a traditional IRA or 401(k) is still the best alternative. If we assume a conservative 8% return, the $5,000 will grow to $10,800 at retirement in 2013. Afterwards, the retiree can withdraw $800 per year ($512 after taxes) without going into principal, still leaving $10,800 ten years later.
On the other hand, because the initial $5,000 contribution is not tax-deductible in a Roth IRA, an investor in the top bracket would invest only $3,400 after taxes and have $6,900 at retirement. To have the same after-tax "income" of $512 a year would keep the account stable at $6,900 in 2023. Putting the same money in a taxable account, with the same after-tax withdrawals, would result in an estate of only $4,900 in 2023.
Increasing the time-to-retirement to 20 years only slightly changes the calculation. Note that under current tax law, the after-tax income could be only $488, and the estates would be $10,800 in the IRA, $6,600 in the Roth, and $3,900 in the taxable account in 2023. The calculations ignore estate tax -- or assume that the elimination of the tax in 2010 also refuses to sunset in 2011, as currently scheduled.
WAIT FOR NEXT YEAR. An IRA or 401(k) thus remains the preferred saving instrument for Americans in higher tax brackets. The advantage is even more pronounced if investors expect to drop into lower tax brackets when they retire. But it's less clear if retirees expect taxes to rise in the future. In either case, however, the Roth IRA still does better than a taxable account, although not as much better than before the new bill was signed into law.
From a macro perspective, most of the short-term stimulus in the bill comes from the lower taxes paid as a result of moving forward the 2001 tax cuts. The dividend and capital-gains cuts have an equivalent impact, but the cash will not be seen by taxpayers until next April 15. And the wealth effect (from the higher value of stocks) takes about a year to be reflected in consumer spending.
Thus the biggest impact of the dividend and capital-gains proposals will be in 2004, not in 2003. The combined impact of all the tax changes should add about a percentage point to the economy's growth rates from the fourth quarter of 2003 through 2004.
THE REAL NUMBERS. Investors may feel like celebrating, but it's also wise to remember that the tax bill is much bigger than the headlines suggest. The current bill is as big as the President's proposal -- at least if the provisions don't sunset in 2008. The true 10-year cost is over $700 billion. The released figure has been held down because Congress only calculated tax losses until 2008, when the bill sunsets.
The $700 billion tax cut will push the federal budget deficit higher which will mean higher bond yields over the long haul. The new rates provide some clear short-term opportunities for stock investors, but easy-does-it likely should be the reaction to this tax cut package.
Copyright 2003, Bloomberg L.P.
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