10 Tips for Making the Most of ’93 Tax Changes
President Clinton’s 1993 tax package had fairly little impact on people owning mutual funds. That’s the good news.
The bad news is that there are still plenty of potentially confusing tax issues for people buying mutual funds these days.
The following 10 tips for the tax season can help point you in the right direction. Most rely more on common sense than numbers, since sound investment planning doesn’t have to be overly quantitative.
1: The higher your income, the more municipal bond mutual funds may make sense. No earthshaking revelation here, just simple math.
An untaxed 5% yield, typical of what’s being paid by muni bond funds today, is equivalent to 8.3% on a competing investment for a person who pays taxes at the top federal rate of 39.6%. But the same 5% yield translates to only 5.9% taxable for someone in the 15% bracket.
2: The higher your income, the more stock funds may make sense. Perhaps the biggest investment impact of Clinton’s tax package was that it raised the top levy on dividend income to 39.6%, while keeping the maximum capital gains tax rate at 28%.
This gives wealthier investors a good reason to switch to appreciation-oriented stock funds over yield-oriented bond products.
3: Tax-sheltered retirement plans are worth using. Employer-provided programs that allow worker contributions, such as a 401(k) and 403(b), and equivalent plans for self-employed people can be great ways to build wealth. They allow tax-deferred growth and reduce your taxable income by the amount you invest. Plus, your company might make a matching investment on your behalf.
If you and your spouse don’t have retirement coverage at work, you can still get tax-deferred growth and a deduction of up to $2,000 each by investing through an individual retirement account. And even with coverage at work, you may still qualify for a full or partial IRA deduction, depending on your income.
4: Variable annuities can make sense if you have additional investment dollars to shelter. These close cousins to mutual funds offer several nice features, including a means of sheltering investment earnings from taxes until the money is withdrawn. Plus, there’s no limit on how much you can invest in annuities, unlike with IRAs and work-related retirement plans.
However, annuities don’t offer deductions or matching provisions. Regard them as your third choice in the retirement planning hierarchy.
5: The more muni bond funds you own, the more likely you are to have taxable gains to report. Only the yields paid by these funds skirt taxes. Any profits resulting from appreciating bond prices are taxable. On average, “tax-free” funds returned about 11.3% in 1993, of which only about half was exempt interest.
6: The more IRAs you own, the more you should consider fund companies that offer no-fee IRA programs. Those $10 to $15 yearly fees--more at some full-service brokerages--add up with multiple accounts.
7: The more worried you are about taxes, the less stock fund investing you should do in December. That’s the month stock funds generally pass their taxable profits on to shareholders for the year.
If you invest shortly before a capital gains declaration, you would buy a piece of the tax liability earned during the year, though you didn’t share in the profits. But when you ultimately sell your stake, you would essentially recoup the money. This caveat wouldn’t apply if you were investing within tax-sheltered accounts.
8: The more you use dollar-cost averaging, the more record keeping you can expect.
With an averaging strategy, you invest a fixed amount regularly--say $100 a month--into the fund of your choice. While great for easing into risky stock funds, the approach can be mildly complicated for record keeping purposes because each purchase is a taxable transaction (assuming your account isn’t sheltered).
9: The less selling you do, the less you need to worry about the three main methods for calculating gains and losses on fund shares--”specific identification,” “first-in, first-out” and “average cost.”
Each will result in a different taxable gain or loss assuming you sell a portion of your shares. If you sell all shares, the tax result will be the same regardless of which approach you take. Many fund companies offer pamphlets describing the various methods in detail.
10: The more you reinvest capital gains distributions and dividends, the better records you should keep.
The rule here is fairly simple: When you reinvest dividends and capital gains distributions in additional shares, you must pay taxes on these amounts--just as if you had received them in cash. But when you ultimately sell your shares, you can narrow the resulting taxable gain (or widen the loss) to reflect the amounts reinvested over the years. Again, this assumes your investment is not in a sheltered account.
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The mutual fund division of San Francisco-based Wells Fargo Bank today is unveiling an unusual array of funds designed for investors in five different stages of life.
The new Stagecoach LifePath portfolios will diversify among up to eight stock and five bond categories, along with a money market component. The funds will invest in indexes rather than individual securities, as the emphasis is on active asset allocation.
For example, the LifePath 2000 fund, designed for people expecting to retire or withdraw cash around the year 2000, will generally have a weighting of about 20% in stocks, 70% in bonds and 10% in cash.
At the other extreme, LifePath 2040, the most aggressive of the bunch, will tend to stay nearly entirely in stocks. The other funds are geared for withdrawals in or around 2010, 2020 or 2030.
Though the funds are focused for the long haul, LifePath managers can change the asset mix as frequently as daily, depending on management’s reaction to market conditions. Over the years, however, each fund’s allocation will tend to grow more conservative, mirroring shareholders’ perceived need for greater income and stability.
When the target year arrives, the funds won’t liquidate but will maintain a conservative posture.
The LifePath funds can be purchased in all 50 states for a $1,000 minimum. Call (800) 935-5746 for more information.
Numbers Worth Knowing
Here are some of the key figures to note for people wishing to reduce the tax bite on their mutual fund investments.
* 28%: Maximum federal tax rate on long-term capital gains paid by stock or bond funds.
* 39.6%: Maximum federal tax rate on dividend or interest income paid by stock, bond or money market funds, applicable to people with income in excess of $250,000. A 36% rate kicks in for people earning more than $140,000 (married filing jointly) or $115,000 (single). A 31% rate applies above $91,850 (married) or $55,100 (single), and 28% above $38,000 (married) or $22,750 (single). Below that, a 15% rate applies.
* $9,240: Maximum that an employee can elect to invest in a 401(k) plan in 1994, up from $8,994 in 1993. Including employer contributions, the ceiling is $30,000 or 25% of the person’s taxable compensation.
* $40,000 to $50,000: Income level between which IRA deductions phase out, for married people with retirement plan coverage at work. For singles with such coverage, IRAs are fully deductible for income below $25,000 and not at all deductible above $35,000.
* 59 1/2: Age below which a 10% penalty may apply on early withdrawals from IRAs, 401(k)s, variable annuities and other retirement vehicles.
