Tax Rate Hikes Alter Strategy for Investors

Wall Street seems to approve of President Clinton’s economic plan, which passed Congress late last week: Stock prices are at or near record highs, and long-term interest rates are at 20-year lows.

But for some individual investors, the tax increases in the new law may encourage significant portfolio shifts.

In brief, blue-chip and smaller growth stocks appear to gain from the tax changes. So do tax-exempt municipal bonds. The likely losers: taxable bonds, such as Treasury issues, and bank savings accounts.

Some questions and answers:

Q. What’s the biggest change wrought by this law for investors?

A. For high-income earners, there now is a big advantage in receiving investment returns in capital gains rather than ordinary income, such as interest or dividends. So we’re back to pre-1986 tax policy.

Under the new law, the top federal tax rate on interest and dividends for couples with taxable income over $140,000 ($115,000 for individuals) rises from 31% to 36%. But long-term capital gains--profit on the sale of investments held more than one year--will continue to be taxed at 28%.

For the top income earners, the advantage is even greater: Interest and dividends paid to people earning over $250,000 will be taxed at 39.6%, versus 28% for capital gains.

And because those individuals also lose some deductions and pay an added Medicare payroll tax, their real top federal tax rate is 42.2%, says Suzzanne Brubaker-Wolfe, manager in personal financial planning for Arthur Andersen & Co. in Los Angeles.

Q. What about middle- and lower-income earners?

A. Their top tax rate on ordinary income remains 31%, so there is an advantage to them as well in receiving capital gains over interest and dividends. But it’s certainly not enough to warrant wholesale changes in an investment plan.

Q. Should higher-income investors contemplate big changes in their investment portfolios?

A. Let’s start by saying that you should never make an investment decision solely for tax reasons.

Beyond that, tax advisers say that high-income investors whose portfolios now are skewed heavily toward interest-paying securities (such as taxable bonds or bank CDs) or high-dividend stocks (such as utilities) may want to move some of those assets into investments more likely to generate capital gains.

Q. Like what, for example?

A. Jeff Saccacio, director of personal financial services for Coopers & Lybrand in Los Angeles, figures that many high-income investors “will be driven toward ‘growth-and-income’ stock mutual funds to supplement their fixed-income investments.”

Growth-and-income funds typically own blue-chip multinational stocks that pay decent dividends, but also offer appreciation potential as the economy grows.

Let’s say a taxpayer in the new 39.6% federal tax bracket expects to earn the same 8% return off a $50,000 growth-and-income stock portfolio and a $50,000 taxable bond portfolio over one year.

Assume that in the case of the bond portfolio, that 8% is all from interest income, while the stock portfolio return is 3% from dividends and 5% from capital gains:

* The 8% bond interest ($4,000 on $50,000) is taxed at 39.6%, leaving $2,416 after tax.

* The 8% stock return would be taxed 39.6% on the dividends, but just 28% on the capital gains. End result: The investor keeps $2,706 after tax, or $290 more than the bond portfolio return.

Q. What about smaller growth stocks? Don’t they offer greater capital gains potential?

A. They do. And in fact, one provision of the tax law gives investors an added break on capital gains from investments in small firms, Saccacio notes. Instead of a 28% gains tax, returns on shares of qualified companies will be taxed at just 14% if held for five years.

But the securities that can get this break are limited (generally, they must be manufacturers). Wall Street is expected to respond to this provision by packaging shares of emerging growth firms into funds meant to be held five years.

Note, though, that the operative word with all capital gains is “potential”: An investment may produce a gain, but it may just as easily produce a loss instead.

That’s why, despite higher taxes on ordinary income, it makes little sense for conservative investors to shift too much from relatively safe bonds to high-risk stocks. But if you need more growth in your portfolio anyway (and many people do), the new law is your friend.

Q. Are there ways to convert ordinary income into capital gains to get the lower tax rate?

A. There are--but Congress is already anticipating such transactions, and the new law specifically bars them.

Generally, “conversion” transactions involve situations where an investor buys an asset with the expressed intent to sell it later at a set price. What you might deem a capital gain in the ownership period might be deemed ordinary income by Uncle Sam.

A better, legal idea for executives: Take more compensation in the form of incentive stock options and less in straight salary.

Finally, all high-income investors need to keep in mind the Alternative Minimum Tax, which kicks in when you benefit from certain deductions or tax-avoiding investments.

Q. Are there legitimate tax shelters left today?

A. Besides firm-sponsored or individual retirement plans, two shelters remain. One is the annuity, which allows you to invest in a mutual-fundlike stock or bond portfolio whose returns build up tax-free until you retire.

Second, tax-exempt municipal bonds remain a great idea, especially for Californians, who face high state income taxes as well. “Muni bonds have to be a much bigger part of (high-income) peoples’ portfolios now,” says Eugene Krieger, managing partner for Southern California tax practice at Price Waterhouse.

Long-term muni bonds yield in the 5.5% to 6.0% range. Investors in the new, higher tax brackets would have to earn 9.5% to 11% on taxable bonds to match those muni yields. Given that 30-year Treasury bonds yield just 6.53%, it should be obvious that munis are difficult or impossible to beat.

Q. But aren’t muni bonds subject to a special tax?

A. Indirectly, yes. For higher-income retirees, muni bond income is added to taxable income to determine what portion of Social Security benefits are taxable.

Thus, retirees who have significant investment income should consult an accountant or other tax expert before shifting heavily into muni bonds: There may be a particular mix of muni bonds and growth-oriented investments (such as stock funds) that is best for you, based on your tax status.

Q. What’s the best way to own muni bonds?

A. Bond mutual funds are the easiest way because they let you own a piece of a diversified portfolio of bonds--important in California today, given that it can be hard to judge the health of a particular municipality as the state’s recession drags on.

But bond funds’ yields can fluctuate, and if market interest rates rise, the value of fund shares can decline as older bonds lose value.

Janice Hobbs, head of Innovative Financial Planning in Tustin, says many clients still prefer single munis over funds because “they know that with (individual) bonds, some day they’ll get their investment back” in full, if they hold the bond to maturity (and assuming the issuer has no problems).

For those investors, Hobbs suggests bond unit trusts instead. The trusts, sold by brokers and financial planners, are shares in diversified pools of bonds that mature at about the same time in the future. Because the pools are fixed (unlike bond funds, which actively trade bonds), your interest income stays constant for the life of the bonds.