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President Bush's $350 billion tax-cut package signed into law on May 28 creates befuddlement as well as opportunity for the individual investor. Financial planners and accountants are still sorting out how the new law will affect taxpayers. And economists are parsing what impact the changes will have on investing behavior and economic growth, which remains sluggish. But it's not too early for investors to begin their own investigation of how the tax-law changes might affect their portfolios and investing strategies.
The lower capital gains rate (15% from 20%) and much lower dividend rate (15% from 38.6%) suggest that portfolios should be shifted more to stocks. Indeed, some of this may already be happening, as the major market indices closed higher for six of the past seven trading sessions.
Just as important, the new law reduces the benefits of tax deferment in traditional retirement saving 401(k) and IRA accounts. But complicating the outlook for investors is the fact that the tax breaks are scheduled to end after 2007. If that happens -- and there's a great deal of debate in Washington and on Wall Street about whether it will -- investors should proceed judiciously in planning to shift their asset allocation. Here are some things to consider in that process:
AIMING HIGHER. For taxable accounts, investors should probably include more high-dividend stocks. There's no question that if the law were permanent, this would be a good move. As it is, the question of how far the portfolio should be slanted depends on whether you believe the dividend provisions will expire, or "sunset," in five years.
If you load up on high-dividend stocks and Congress allows the dividend rate to go back to the ordinary income rate in 2008, as the legislation states, you would be joining other investors in selling off those stocks at fire-sale prices. My advice would be to shift your taxable portfolio toward more high-dividend stocks, and cut back on bonds, but don't go hog wild.
And be careful which high-dividend stocks you add. Not all dividends will be taxed at the 15% rate. In particular, stocks and mutual funds that are simply a pass-through of income, such as real-estate investment trusts (REITs), still will be subject to ordinary tax rates. Most foreign corporations' dividends also will be subject to full tax rates. Until the Internal Revenue Service writes the final regulations, these would be a gray area to avoid.
GAIN SAYINGS. Stocks will benefit from capital-gains as well as dividend changes. If the tax law change were permanent, the price of common stocks should rise an average of 5% (or 46 points on the S&P 500 stock-index from its May 27 close of 951), with high-dividend stocks rising somewhat more. My personal guess is that dividends will be treated the same as capital gains even after 2008, but it's clearly uncertain. Stocks will thus rise somewhat less than 5% on average. If we assume 50% odds, the S&P 500 should rise 23 points, or about what it has gone up since the compromise on the tax bill was reached.
Take your losses, but let the gains run at least a year to get the lower tax rate. The lower rate increases the importance of holding assets until you can claim capital gains. It also increases the advantage of mutual funds that trade less frequently, such as index funds, since almost all their capital gains are long term.
Dividends aren't likely to increase much, since the sunset provision gives chief financial officers a clear motive not to change dividend policy significantly. If the tax breaks are temporary, there's little reason for corporations to pay higher dividends, especially if executives feel the market will punish the stock if dividends are cut in 2008. More closely-held corporations are more likely to increase dividends, especially if the change is temporary, because this would be a one-time opportunity to distribute low tax income to the owners.
Copyright 2003, by The McGraw-Hill Companies Inc. All rights reserved.
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