HOW A CAPITAL-GAINS CUT WILL CHANGE THE WAY YOU INVEST
(MONEY Magazine) – THIS MONTH: --Pension lessons from a baseball pro --Websites for fund investors --When it pays to buy cash-value life insurance
In the past, investors banking on a capital-gains tax cut have felt like Charlie Brown as Lucy repeatedly yanks away the football when he's about to kick it. Perk up: Veteran Washington watchers say this year investors like you really will get capital-gains relief. Says Clint Stretch, director of tax legislative affairs for the accounting firm Deloitte & Touche: "It's 90% likely we'll get a substantial cap-gains cut by August." If Stretch and others are right--and we think they are--you will need to consider future purchases of taxable and tax-deferred investments in entirely new ways.
As MONEY went to press, the House and Senate had passed the following:
--A deep cut in the top capital-gains tax rate to 20% from 28%, and to 10% from 15% for taxpayers in the lowest income tax bracket (singles with taxable income of $24,650 or less, couples $41,200 or less)
--An exclusion from tax of up to $500,000 in profits for married couples who are selling their homes ($250,000 for singles)
--A new tax credit for children under 17--$500 a child for married couples with an adjusted gross income of $110,000 or less ($75,000 or less for single parents)
--A hike to $1 million from $600,000 in the amount you can pass to heirs other than your spouse free of tax
President Clinton has countered with a child-care credit and home-sale exclusion close to the two bills but a somewhat different capital-gains cut--reducing the top rate to 27.72%. The likeliest outcome, according to MONEY's sources, is that Republicans and the White House will agree to lower the top tax rate to 20% on investment assets sold after May 7 of this year.
So where does that leave you? Before rejiggering your portfolio, remember that you should never sell investments just for tax reasons. (For advice on which holdings you should consider unloading because of the market's run-up, see "Now's the Time to Sell Some Stock" on page 68.) That said, on the assumption that a capital-gains tax cut is on its way, here are the three most important things to keep in mind:
--In certain cases, you will be better off putting money into taxable investments than into nondeductible IRAs and tax-deferred annuities. With today's 28% top cap-gains rate, it usually makes more tax sense for an investor in the 28% bracket (married couples with taxable income of $41,201 to $99,600, singles with $24,651 to $59,750) or higher to choose a tax-deferred investment over a taxable account. With a 20% maximum rate on capital gains, however, the equation changes for many investors (see the table above). The reason: Every dollar of investment earnings you withdraw from a tax-deferred account gets taxed at your ordinary-income rate, which under the new rules will be higher than your capital-gains rate--no matter what your tax bracket is.
Annuities, especially, would suffer. Says Marc Britton, director of personal financial planning at accounting firm KPMG Peat Marwick in New York City: "Because high insurance expenses eat into annuities' returns, there will be less reason to own them if the capital-gains tax is cut substantially." Nondeductible IRAs still make sense for equity investors with a long-term time horizon of 10 years or more, however. And if you already own an annuity or nondeductible IRA? Hold on to it. Otherwise you'll end up paying a 10% tax penalty (if you're under age 59 1/2) plus income tax on the earnings. You can check to see how much more your investments would return with a lower cap-gains rate at our Website (http://money.com) or on CompuServe (at GO MONEY).
--All other things being equal, favor growth stocks over income-producing stocks and bonds in your taxable accounts. Stock dividends and bond interest payments are taxed at your ordinary-income tax rate, which can be as high as 39.6%--a figure that won't drop this year. By contrast, long-term capital gains from stocks held more than 12 months would be taxed at a maximum of 20%. Since growth stocks typically pay small dividends or none at all, most of your profit from them would end up being taxed at the lower cap-gains rate. For example, a 28%-bracket investor with $1,000 in dividends or interest would pay $280 in tax, pocketing just $720. On a $1,000 gain from stock appreciation, however, he would pay just $200 in tax, netting a more generous $800. The higher your income tax rate, the more you'd benefit from this approach.
--Even with a capital-gains cut, 401(k)s will generally remain your best investment of all. That's because you get to invest pretax money. So if you decided to invest $2,000 of your earnings in a 401(k), the full amount would be invested. If you chose to stash that money elsewhere, though, you would first be taxed on the cash, leaving a 28% bracket investor with only $1,440 to invest. Then too, many employers sweeten their 401(k) plans with a match of 50[cents] for every dollar you contribute. Even Uncle Sam can't compete with that.