Tax Plan May Not Spur Saving and Investment

Times Staff Writer

President Reagan told the nation last week that his new tax overhaul plan will boost saving and investment, but the nation’s savers and investors may not oblige him--at least not as much as he hopes.

Reagan’s proposal gives conflicting and confusing signals to investors, with parts of it encouraging them to save and invest while other parts discourage them from doing so, tax experts and economists say.

Although the plan would promote savings by increasing the amount certain individuals may contribute to individual retirement accounts, it would deter savings with rules that make company tax-deferred savings plans and whole-life insurance policies less attractive. Similarly, the plan would promote investment in stocks and bonds but would discourage investment in real estate.

The plan also clearly favors some individuals over others.


Renters Would Be Hurt

The increase in the personal exemption, from $1,040 this year to $2,000, should slash the taxes of households with children much more than for working couples without children. Renters are expected to be hurt disproportionately if rents increase because of reduced tax benefits for shelters that rely on investment in apartment buildings.

And because state and local taxes would no longer be deductible under the Reagan plan, residents of high-tax states such as California would fare more poorly than those in states with low state taxes.

Because of these conflicting signals and varying impacts, there is wide doubt over whether individuals would act as Reagan hopes.


“I don’t see that much of an increase in savings,” said Stuart J. Brahs, executive director of the Assn. of Private Pension and Welfare Plans, noting that stricter rules might discourage many companies from setting up tax-deferred company savings plans.

Understandably, investors and their advisers are scrambling to find loopholes in the Reagan plan, or to act before any reforms might take effect. Many investors are being urged to take write-offs this year, while individual tax rates are as high as 50%, and save income for later years, when the maximum rate would fall to 35%.

Investors also are being urged to make charitable contributions this year, given that tax rates would decline and that fewer taxpayers are expected to itemize under the Reagan plan. As is the case now, the Reagan plan would allow charitable deductions only for taxpayers who itemize.

In addition, investors might scramble to buy life insurance policies now to avoid a proposed tax on the accumulated increase in the savings portion or “cash value” of the policies. And those interested in buying second homes might take a second mortgage on their first home, getting full interest deductions, to get cash to buy the second home because interest payments might not be fully deductible for non-primary residences.


Caution Advised

But investors should be careful not to act too fast and invest in an uneconomical deal, advisers say.

“The first thing to do is don’t panic,” said Ira Shapiro, director of tax policy at the Washington office of Coopers & Lybrand, a major accounting firm. “It’s not certain the bill will pass and, even if it does, it may be changed significantly.”

“If you find any investment that makes economic sense and you were probably going to do it anyway, do it now,” advised Neil Alexander of the Los Angeles investment advisory firm of Alexander Associates. But “don’t do it just in anticipation of tax changes,” he said.


Here’s a look at how the Reagan plan would affect various areas of investment and financial planning and what investors can do to prepare for any changes:


Perhaps no other investment area would be affected more by the Reagan plan than real estate. Owners of single-family homes would be hurt by Reagan’s proposed elimination of deductions for property taxes and because the mortgage interest deduction would be worth less with lower tax rates.

Buyers of second homes would be discouraged by Reagan’s proposal to limit interest deductions for anything other than a primary home. And real estate tax shelters would be hammered by a rule that limits write-offs to the amount an investor could risk losing.


“It is clear that the after-tax cost of homeownership will go up, " said an analyst with the National Assn. of Realtors. If mortgage rates remain unchanged and the tax proposal becomes law, the cost of owning a typical $85,000 home would rise by $1,095 a year, the association says.

People who want to find and fix an old home in a historic neighborhood could be deterred because the rehabilitation tax credit would be abolished. And the supply of low-income housing would dwindle because Reagan is proposing to end federal tax-exempt status for state and local bonds that finance private projects such as housing.

Interest Deductions

Second homes might also decline in value because of the Reagan plan to limit interest deductions on investments other than primary residences to $5,000 plus the taxpayer’s investment income. Thus, a person with income of $3,000 from investments such as stocks and bonds could not write off more than $8,000 for interest.


But some analysts say the negative impact on second homes might be limited. Kenneth Leventhal, co-managing partner of a Los Angeles-based accounting firm bearing his name, says a study by his firm showed that 72% of second-home buyers have enough investment income anyway and thus would be unaffected by the rule limiting interest deductions to $5,000 plus investment income.

The negative impact on primary homes also might be dampened over the long term, some analysts say, because the Reagan plan would put additional cash in the hands of many taxpayers and could lead to increased demand for homes from renters. The rule limiting real estate tax shelter write-offs to the amount an investor could lose would severely cut the attractiveness of such shelters, which build a great number of apartment complexes.

The National Assn. of Homebuilders says rents theoretically would have to rise by 20% to 30% to give investors the same after-tax return. If rent-control measures prevent such increases, “the value of (apartment) properties will go down,” said Eli Broad, chairman and chief executive of Los Angeles-based Kaufman & Broad, a major home builder.



Lower taxes and reduced inflation in recent years already have prompted many promoters of tax shelters to restructure their deals in order to reduce the tax benefits and increase the income for investors. That trend would accelerate under Reagan’s plan.

Real estate partnerships, by far the most popular form of tax shelters, “will see a big shakeout if the Reagan plan passes,” said Arnold G. Rudoff, director of partnership analysis for Price Waterhouse, a major accounting firm.

The proposal to limit interest deductions on real estate to what is “at risk” would discourage many new shelters that would offer investors initial write-offs far larger than their cash investments, he said.

At-Risk Provisions


Under current law, investors could initially write off, say, $5,000, even though only $1,000 of that is their own money. The other $4,000 is borrowed by the partnership. Under the Reagan plan, however, only the $1,000 which is “at risk” would be deductible, unless the investor takes personal responsibility for the $4,000 portion of the loan should the real estate investment collapse. Such at-risk provisions now apply to all tax shelters except real estate.

Also hurting real estate shelters is the Reagan proposal that profits on real estate purchased strictly for investment purposes no longer be taxed at the capital gains rate, but instead as ordinary income, after adjusting for inflation. And the depreciation period for real estate would be lengthened to 28 years from 18 now.

Investors may want to invest in such shelters now before the changes take effect, Rudoff said. One advantage in doing so, he said, is that income in later years from the partnerships would be taxed at a lower rate under Reagan’s proposed tax rate reductions.

Effect on Other Shelters


Other shelters also would be hurt by Reagan’s proposals. Shelters that invest in equipment leasing would suffer because of Reagan’s less generous depreciation rules for capital equipment and the repeal of the investment tax credit, said William H. Sawyer, senior vice president and national marketing manager for Integrated Resources Marketing, Inc., a leading investment firm.

However, oil and gas shelters should remain popular because the Reagan plan retains the provision permitting oil drillers to write off exploration costs, Rudoff said.


Stocks are expected to benefit from the Reagan plan, thanks largely to the lowering of the maximum capital gains tax rate to 17.5% from 20%.


Cuts in the capital gains tax in 1978 and 1981 “brought a lot of money out of mattresses” and into stocks, said Edward I. O’Brien, president of the Securities Industry Assn. “We believe it will work again.”

But, O’Brien adds: “It’s not going to drive the market through the roof.” Other things, such as the strength of the economy and the size of the federal budget deficit, “are just as important, if not more important, than taxes” for stocks, he said.

High-Tech Firms

Investors who do buy stocks might find that Reagan’s tax changes will help some kinds of stocks over others, analysts say. For example, stocks of firms now saddled with high relative tax rates--such as high-tech firms, retailers and service firms--should benefit because the firms would enjoy lower taxes and thus higher profits under the Reagan plan.


Conversely, stocks of firms in capital-intensive industries, such as autos and steel, would be hurt by less generous depreciation write-offs and loss of the investment tax credit.

Investors also might seek stocks with higher dividend pay-outs. Under the Reagan plan, firms may deduct 10% of their dividend payments, so firms that already pay high dividends might pay even more.


Bonds also appear to be favored under the Reagan plan, although to a lesser extent than stocks, analysts say.


Taxable bonds will certainly become more attractive because lower individual tax rates will increase their after-tax returns. Treasury bonds and other government securities that are exempt from state and local taxes also are expected to gain luster if state and local taxes are no longer deductible as Reagan proposes.

However, the picture is less clear for tax-exempt municipal bonds. On the surface, they will be hurt by lower personal tax rates, which would tend to make them less attractive relative to taxable bonds and other taxable investments.

But tax-exempts may benefit from the fact that the availability of real estate partnerships and other tax shelters would be diminished. In addition, Reagan’s proposal to end federal tax-exempt status for municipal bonds that finance private projects, such as hospitals, would decrease the supply of municipal bonds between 40% and 45%, said Steven J. Hueglin, a partner at Gabriele, Hueglin & Cashman Inc., a leading bond-trading firm.

“So municipal bonds will be helped by reducing the supply and reducing alternative tax shelter vehicles,” Hueglin said.



Savers in the nation’s largest credit unions might see a rise in loan rates or service fees, or declines in deposit rates under the Reagan plan. Credit unions with more than $5 million in assets would be taxed much like their bank and savings and loan competitors, at a rate of up to 33%. Credit unions now pay no taxes.

This change would affect about 20% of the nation’s 18,500 credit unions, representing 85% of all credit union assets, estimates Richard Beach, senior director and congressional liaison for the Credit Union National Assn. Such a tax could lead these credit unions to cut interest payments by 0.8 percentage points, raise loan fees by 1 percentage point or raise service fees by 300%, Beach said.

Banks would pay higher taxes under the Reagan plan, but whether it would affect their rates and fees to savers is not yet clear, said Fritz Elmendorf, a spokesman for the American Bankers Assn.



Reagan hopes that his plan will boost contributions to the popular and fast-growing individual retirement accounts by allowing couples with only one working spouse to invest $4,000 a year in the accounts, just as couples with two working spouses are allowed to do. Now, couples with one working spouse may invest only $2,250 a year.

But some experts say the net gain in IRAs resulting from the tax changes may be relatively small. Only about one-fourth of U.S. households have IRAs, and only about one-fourth of those might be able to take advantage of the increase, some IRA experts estimate. Meanwhile, a drop in personal tax rates would make IRAs somewhat less attractive.

More importantly, the Reagan plan would increase the early withdrawal penalty on IRAs to 20%, up from 10%, unless the withdrawal is for certain reasons such as college expenses, purchase of a first principal residence or replacement of certain unemployment benefits. In such cases, the penalty stays at 10%.


“More people might be impacted by this negative feature than will be affected positively,” said Dale Gifford, partner in Hewitt Associates, an employee-benefits consulting firm.

Popular Savings Device

Another popular retirement savings device, the relatively new 401(k) company-savings plan, might lose some of its luster under the Reagan tax plan.

Under a 401(k) plan, employers withhold part of an employee’s before-tax pay in a separate account, which accumulates income on a tax-deferred basis until withdrawn. The plans have become popular with employees because employers usually contribute an added amount into the account, often as much as 50% of the withheld pay.


Reagan has proposed to limit each employee’s contribution to all retirement plans--including IRAs and 401(k)s--to $8,000 a year, down from $30,000 now. That means that if an employee already contributes $2,000 to an IRA, he would be limited to just $6,000 in a 401(k). Analysts say the vast majority of Americans would not be affected by this change because they do not have enough money to save to top the $8,000 limit anyway.

What would negatively impact 401(k) plans, analysts say, would be new rules that make it more difficult for money in the plans to be withdrawn. Under existing rules, employees can withdraw funds under serious financial hardship, such as major medical expenses. But the Reagan proposal would allow employees to withdraw funds only if they retire or leave the company, or if the employer terminates the plan.

For some lower- and middle-income employees, “the inability to have access to a major part of their savings could discourage them from participating,” Gifford said.



Perhaps Reagan’s most significant change of employee benefits is his proposal to tax a portion of company-paid health insurance, now tax free. The Reagan plan would tax the first $10 a month in benefits for individuals and $25 a month for couples filing jointly.

Such a plan could cause some employees, particularly younger ones, who are given a choice to reduce their medical coverage, said Brahs of the Assn. of Private Pension and Welfare Plans.

Or, in families with two working spouses with health plans, one of the spouses might opt to drop coverage completely, he said.

Reagan also has proposed to tax all unemployment compensation, regardless of income level. Under current law, unemployment compensation is taxed only if the recipient’s adjusted gross income exceeds $12,000 a year, or $18,000 for couples filing jointly.



Reagan’s proposal to tax the increase in cash value of life insurance policies, even before the policyholder begins to withdraw it, could mean “the slow death of life insurance companies,” said Robert Haskell, a spokesman for Pacific Mutual Life Insurance Co. Now, any accumulation is taxed only when the policyholder withdraws it.

But, while the change might discourage future life insurance sales, it is expected to boost sales in the short run because the new rule would not apply to policies written before the change took effect.

“I wouldn’t be surprised if it (a jump in sales) hasn’t already started,” said James Dederer, senior vice president and general counsel for Los Angeles-based Transamerica Occidental Life Insurance Co. “Insurance agents are very creative, and they’ll use any edge they can get to increase sales.”



The Reagan tax plan sharply attacks plans that allow parents to lower their taxes or finance their children’s college education by shifting income and assets to their children, who typically are in lower tax brackets.

Reagan’s plan would kill so-called Clifford trusts, a popular device under which a parent places assets such as stocks and bonds in a trust and names a child as beneficiary. The child receives the income from the trust, which is taxed at the child’s lower rate. After 10 years and a day, the parents can dissolve the trust and reclaim the entire amount.

Investors could start a Clifford trust now before any Reagan changes take effect, but such a move would be risky because it is not clear whether the Reagan plan would allow future earnings from existing trusts to be taxed at the child’s lower rate, investment adviser Alexander said.


However, custodial accounts are expected to remain popular under the Reagan plan. Under these plans, parents may give to children assets that are managed by the parents but taxed at the child’s rate. Unlike a Clifford trust, however, custodial accounts would require that the child must eventually take possession.

Reagan’s plan would tax the earnings of custodial accounts at the parents’ rates for the years that the child is under 14. Once over 14, the earnings would be taxed at the child’s rate. Now, the earnings are taxed entirely at the child’s rate, regardless of age.

Times staff writers Oswald Johnston and Robert A. Rosenblatt in Washington and Heidi Evans in Orange County contributed to this story.