A New Retirement Tactic For U.S.'s New Tax Law

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A New Retirement Tactic For U.S.'s New Tax Law

By Jonathan Clements and Tom Herman,Wall Street Journal

May 29, 2003

The new tax law raises a tricky question: How should you divvy up your stocks and bonds between your tax-advantaged retirement accounts and your taxable accounts?

The tax law signed Wednesday by President Bush generally strengthens the case for millions of investors to buy and hold stocks in their regular accounts, while favoring bonds in their 401(k)s and other tax-advantaged retirement plans.

Why is that? Under the new tax law, there will be a top tax rate of just 15% on stock dividends and on long-term capital gains. That's less than half the maximum tax rate, 35%, on ordinary income, which includes interest payments from bonds. Thus, most investors will get the biggest tax savings by putting bonds in their tax-advantaged accounts.

"The change increases the incentive for investors to hold stocks outside of tax-exempt accounts," says David Hariton, a partner at the law firm of Sullivan & Cromwell and a specialist in the tax treatment of financial instruments.

The new tax law means that investors should favor high-quality and high-yield taxable bonds, real-estate investment trusts and short-term stock holdings in their retirement accounts. For taxable accounts, investors should look to stock index funds, tax-managed funds and long-term stock holdings.

Trillions of dollars are at stake. David L. Wray, president of the Profit Sharing/401(k) Council of America in Chicago, says there is more than $4.5 trillion in company defined-contribution plans and individual retirement accounts alone. About 60% of that money is invested in equities and 40% in bonds and other fixed-income instruments.

As always, you shouldn't make investment decisions based solely on tax considerations. First, you should decide on the allocation of stocks and bonds that make sense for you. Then divide your investments between your accounts in a way that minimizes your tax bill.

Just because the tax law has changed doesn't mean investors should promptly do a lot of buying and selling in their accounts. Instead, people should first try to restructure their portfolios with new savings, so they avoid a lot of unnecessary trading, which itself could lead to big tax bills.

As you revamp your portfolio, keep in mind one possible hitch: These changes on dividends and capital gains are scheduled to run through the end of 2008. Nobody knows what will happen after that, although Republican leaders in Congress are expected to try to make these and other changes in the new law permanent.

Here's one model for allocating funds to take advantage of the recent changes. Suppose you have a $300,000 portfolio, with $150,000 in a taxable account and $150,000 in retirement accounts. Let's say your goal is to own 70% stocks and 30% bonds, which means you want $210,000 in stocks and $90,000 in bonds.

The smart move probably is to use the retirement account to buy $90,000 in taxable bonds. With a 401(k) or traditional IRA, you will eventually pay income taxes on your withdrawals. But the tax bill is put off until retirement, thus allowing tax-deferred growth.

Next, turn to your stock-market money. Your goal is to purchase $210,000 in stocks and stock funds. But after buying the bonds, you have just $60,000 left in your retirement account. The objective: Use the retirement account to buy the stocks that will generate the biggest tax bills, while pursuing more tax-efficient stock-market strategies in your taxable account.

What counts as tax efficient? Under the new law, you will end up with the smallest tax bill if you earn long-term capital gains, by buying stocks and holding them for over a year. With these long-term gains, your stock-market profits will be taxed at a maximum 15%, and the tax bill doesn't come due until the winning stocks are sold.

The law treats dividends almost as kindly. As with long-term capital gains, the maximum rate on dividends is just 15%. But you have to pay the dividend tax every year, while you can postpone your long-term capital-gains taxes until you sell your stocks.

What about short-term capital gains, resulting from stock-market winners sold after you've held them one year or less? The news isn't so good. Like interest income, short-term capital gains are taxed at income-tax rates. True, Congress cut income-tax rates in the new law. But that still means tax rates as high as 35%, far above the 15% maximum rate on dividends and long-term capital gains.

Bottom line: In your taxable account, you want to shoot for long-term capital gains, you don't mind dividends and you want to avoid short-term capital gains.

To that end, you might use your $150,000 in taxable-account money to pursue tax-efficient strategies like buying and holding individual stocks, purchasing tax-managed funds or investing in market-tracking index funds. Such strategies are attractive because they don't involve a lot of trading and thus they don't generate large amounts of short-term capital gains.

Meanwhile, use your remaining $60,000 in retirement-account money to pursue less tax-efficient strategies. For example, suppose you are convinced you can beat the stock market by darting in and out of carefully chosen stocks at short-term intervals, with the goal of generating large amounts of short-term capital gains. In that case, you might want to try this trading in your retirement account, where you can defer taxes on any gains.

You might also want to use your retirement-account money to buy real-estate investment trusts. Sure, REITs pay out most of their earnings each year in dividends. But the new tax law still treats most REIT dividends as ordinary income, taxable at higher rates. Likewise, you might use your retirement account to invest in high-turnover stock funds, which tend to generate big tax bills.

Whatever mix of retirement and taxable money you have, be sure to build a balanced portfolio. For instance, you may not have much retirement-account money. But that doesn't mean you should skimp on bonds. Instead, you could always purchase tax-free municipal bonds in your taxable account.