The New Tax Act: Should You Revamp Your Portfolio?

    by Maria Crawford Scott

    The New Tax Act: Should You Revamp Your Portfolio? Splash image

    Lower tax rates for taxable investments are one reason to cheer the new tax act.

    But making certain investment decisions, particularly regarding taxable versus tax-deferred assets, won’t be any easier.

    Under the Jobs and Growth Reconciliation Tax Act of 2003, qualified dividends and long-term capital gains are taxed at a maximum rate of 15%; under the old rates, dividends were taxed as ordinary income at a maximum rate of 38.6%, and long-term capital gains had a top rate of 20%. Short-term gains are still taxed as ordinary income. The new rate applies to qualified dividends received on or after January 1, 2003 and long-term capital gains (held more than one year) realized on or after May 6, 2003.

    However, all of the changes are in effect for only 5½ years, through 2008—in 2009, all rates revert back to the 2002 levels unless Congress acts to extend the lower rates. And that makes long-term planning very difficult. Yet the new rates have raised a number of issues for investors, in particular the relative benefits provided by tax-deferred accounts compared to taxable investments under the new rates. A recent analysis of these issues by T. Rowe Price provides some guidance.

    Is Tax-Deferral Better?

    Under the 2003 Tax Act, earnings in tax-deferred retirement plans (excluding Roth IRAs) are still taxed at ordinary income tax rates when they are withdrawn. That means that stock investments within these plans lose the favorable tax treatment on dividends and capital gains that they would receive if held in a taxable account. Are tax-deferred accounts still worth it?

    To study this issue, T. Rowe Price examined the potential aftertax returns of investments in a growth stock fund and an equity-income fund in three different types of accounts: a deductible tax-deferred account, such as a 401(k) or deductible IRA, a non-deductible tax-deferred account such as a non-deductible IRA or variable annuity, and a taxable account. It assumed an 8% average annual total return, with the dividend and capital gain components based on the actual performance of those types of funds as tracked by Morningstar for the 15-year period ending 2002. The 8% return assumption was used because it was felt to be more realistic in terms of future performance, rather than the unusually high returns earned over the last 15 years.

    Importantly, the study assumed that the new rates would be in effect over the entire time period examined, even though in reality the new rates are scheduled to revert back to the old rates in 2009.

    The study compared the aftertax values of the accounts assuming they are liquidated at the end of the period, with earnings taxed at ordinary rates for the tax-deferred account, and at the new 15% rate for the taxable account. The assumed income tax rate was 27% under the old law and 25% under the new law.

    Annual pretax investments of $5,000 were invested in the deductible tax-deferred accounts, while comparable aftertax annual investments were put into the non-deductible tax-deferred account and the taxable account. That’s because, in reality, someone who earned $5,000 in salary could invest all of it on a pretax basis in a 401(k), but considerably less in a taxable or non-deductible tax-deferred account after paying income taxes on the $5,000.

    Table 1 shows the results of the analysis for deductible tax-deferred accounts. Under the new law, the deductible tax-deferred account retains its advantage over the taxable account, although its relative advantage compared with the taxable account is not as great as it was under the old tax law. This was the case for investments in both the growth fund, as well as the equity-income fund. For example, after 15 years, the aftertax value of an equity-income investment that was in a deductible tax-deferred account would amount to $104,468 under the new rates, compared to $91,709 for a taxable account. That’s a $12,759 advantage—not insignificant, but not as significant as the $16,280 advantage ($101,682 compared to $85,402) under the old rates.

    Thus, for investors who do all of their retirement investing in their 401(k) and/or deductible IRA plans, they should continue to do so without regard to the change in taxation on dividends and capital gains.

    The advantage of tax-deferral substantially declines, however, if you assume equal amounts invested in each type of account with aftertax dollars, which would apply in the case of a non-deductible IRA or a variable annuity, as shown in Table 2. In this instance, the breakeven year—when the tax-deferral advantages overcome the lower tax rates in the taxable accounts—is extended to 24 years under the new law compared to just 11 years under the old law for an investment in an equity-income fund; for the growth fund it is extended to 25 years under the new law, compared to 16 under the old law.

    Thus, the new tax rates reduce the appeal of holding equity funds in a non-deductible IRA or variable annuity fund.

    Asset Allocation

    For investors who already hold long-term retirement investments in taxable and tax-deferred accounts, the new rates raise the issue of asset location.

    For example, under the new tax rates, is it more beneficial to hold equity investments in your taxable accounts to take advantage of the lower tax rates on dividends and long-term capital gains, and hold other types of investments, whose earnings are taxed at ordinary income rates, in tax-deferred accounts?

    The potential benefits of this strategy were also examined by the T. Rowe Price study, which once again assumed that the new tax rates would remain in effect past their 2008 expiration.

    The analysis assumed a $20,000 total portfolio, split equally between a growth stock fund and a bond fund. The funds earned the actual returns for their category over the past 20 years through 2002, as tracked by Morningstar.

    The study compared the aftertax value of two portfolios: one in which the growth stock fund was in a deductible tax-deferred account and the bond fund was in the taxable account, and the other in which those holdings were reversed. The results are shown in Table 3.

    The study found that, for an investor in the 28.75% tax bracket (25% federal, 5% state), the aftertax value of the account would be about $95,076 if the growth stock fund were held in the taxable account and the bond fund in the tax-deferred account. If the holdings were reversed, the total aftertax value would be about $87,795, or 8.3% less.

    Over the last 20 years, however, the growth fund had an average annual return of 10.5% and the bond fund had an unusually high 8.9%. This 1.6 percentage point difference was relatively narrow. For that reason, the T. Rowe Price study also made the comparison assuming 9% growth stock fund returns and 6% bond fund returns, an average annual spread of three percentage points that is more in line with historical performance. In that instance, the study found that it would only have been significantly beneficial to place the stock fund in the taxable account for taxpayers in the higher tax brackets when the money was withdrawn. This is because compounding the higher return of the stock fund on a tax-deferred basis over a long time can offset the disadvantage of taxing the earnings at a somewhat higher rate upon withdrawal.

    [T. Rowe Price also ran similar comparisons using equal amounts of aftertax investments in each account to isolate the pure tax consequences of the rate changes. A true 50% stock/50% bond allocation would be based on comparable aftertax amounts in each account. This comparison, however, produced results similar to those in Table 3.]

    The study’s conclusions: A lot will depend on the relative performance of stocks and bonds over your investment period, the length of the investment period, your ordinary income tax rate when the money is withdrawn—and, most unpredictably, further changes in tax policy.

    In addition, stocks held in a tax-deferred account are not eligible for capital loss treatment and do not receive the step-up in cost basis when the owner dies, benefits that were not considered in this particular study.


    Given the uncertainties—and ironically the one almost-certainty that tax rates will change at some point over most long-term investors’ time horizons—it would probably be unwise for investors to revamp their portfolio strategy or structure based on these tax changes alone.

    T. Rowe Price concludes that investors are best served by remaining focused on the asset allocation decision—having a well-balanced, diversified portfolio that suits your risk profile. While you should take taxes into consideration, making long-term planning decisions on the basis of short-term tax policy could lead to unsound planning.

    Maria Crawford Scott is editor of the AAII Journal.

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