The new federal tax-cut package poses a dilemma for professional financial planners such as Scott Leonard.
Cuts in capital gains tax rates and relief from the so-called marriage penalty should spur many Americans to reorganize their financial lives. But many of the breaks are fleeting, changing or expiring at various times over the next 10 years through what are known as sunset provisions.
“It is extremely unfair to the American public to change the tax law every year -- or have the changes evaporate after a few years,” said Leonard, a certified financial planner with Leonard Wealth Management in El Segundo.
Even with the uncertainty, the new tax law does encourage some rethinking and rejiggering of investments, planners say, especially since tax provisions that include sunset provisions are often revived or extended.
But certain strategies -- especially those that rely on tax laws remaining consistent over long periods -- may be risky.
“The tax situation has changed in a number of ways, but some of the changes are temporary, some may be made permanent, some may be improved even more,” said Charles E. Foster II, a certified financial planner with Blankinship & Foster in Del Mar. “Our first advice to clients is to do things in moderation. Don’t push planning so far in one direction that a change in the tax law could make what you’ve done foolish.”
Here are a few strategies for taking advantage of the new tax cuts:
Tax-deductible retirement accounts remain a great deal, said Bernie Kent, a partner specializing in tax and financial planning at PricewaterhouseCoopers in Detroit. But nondeductible retirement accounts such as variable annuities are tough to justify.
Variable annuities are investment accounts, wrapped in an insurance policy. That insurance policy gives the investments tax-deferred status and annuity owners can trade without paying current-year capital gains taxes on their profits.
However, the insurance coverage also costs money -- an average of about 1.4% of the account’s value each year. Also, money held in a variable annuity is treated like money in a tax-favored retirement plan, which means that when withdrawn it is subject to ordinary income tax rates -- not the typically lower capital gains rates.
With capital gains rates slashed to a maximum of 15%, the tax disadvantages of annuities loom larger than ever, said Brent Brodeski, managing director of Savant Capital Management in Rockford, Ill.
Planners said they aren’t necessarily advising clients to sell their annuities, because that could trigger both tax penalties and so-called surrender charges. But many suggested that clients stop putting money into them.
“The new tax changes should be the final nail in the coffin for the variable annuity industry,” Brodeski said.
Some people still may appreciate annuity guarantees, which have become increasingly sophisticated in recent years, said Gumer Alvero, general manager and executive vice president of annuities for American Express Financial Advisors in Minneapolis. Those guarantees, which are covered by the insurance-policy portion of the product, can assure owners that their investments don’t decline in value. But the greater the guarantee, the higher the price tag.
Particularly for buy-and-hold investors, the economic advantage of the annuity’s tax deferral is largely wiped out by the higher fees and the higher tax rates in the end, Brodeski said.
Pay Off the Mortgage
Congress attacked the marriage penalty by hiking the standard deduction for married couples by $1,550 to $9,500 -- exactly twice the amount for a single taxpayer. Congress also widened the 15% tax bracket for married couples.
These changes nearly beg middle-income couples -- particularly retirees -- to take whatever cash they have handy and use it to pay off the mortgage.
The old tax law already favored this approach, planners note, but the new law, coupled with low interest rates, makes it even more compelling. That’s because taxpayers can claim the larger of either their itemized deductions -- mainly mortgage interest, charitable contributions, property taxes and business expenses -- or the standard deduction. With a higher standard deduction, it’s tougher to reach the threshold where itemizing makes sense.
The wider 15% tax bracket also means that more income will be taxed at low rates, making itemized deductions comparatively less valuable.
Consider a couple earning $50,000 a year in wages and pensions, and $10,000 from interest earned on a $200,000 savings account. They also have a $200,000 mortgage at 5.5%.
The couple’s mortgage payments are $1,135.58 a month, or $13,627 a year, but part of that is principal repayment, which is not deductible. Their total itemized deductions are roughly $14,000, which exceeded the standard deduction under the old law by about $6,000.
Because their income is taxed at low rates -- 10% to 15% -- claiming the mortgage interest deduction provided an annual savings of $900 over taking the standard deduction.
Under the new law, this couple’s itemized deductions exceed the standard deduction by only about $4,500, cutting their tax savings to $675.
The smart move would be to use the savings account to pay off the mortgage. The couple would lose the $10,000 in interest earned on their savings, but they would eliminate the need to make $13,627 in principal and interest payments on the home loan. That improves their cash flow by $3,627.
Meanwhile, losing the investment income causes a drop in taxable income and federal income tax. Savings: $1,125. Overall, paying off the mortgage boosts this couple’s spending power by $4,752 a year.
This strategy made sense before the new law passed, so it makes little difference that the marriage penalty relief is set to expire in 2004.
High-Income and Open
to Risks? Borrow Big
High-income taxpayers with an appetite for speculation and an unshakeable faith in the stock market might consider a risky but potentially rewarding strategy that plays off the new lower capital gains rates -- taking out a home equity loan and investing it in equities.
If a couple in the 35% tax bracket borrowed an extra $100,000 against their home with a 5.5% 30-year, fixed-rate loan, their monthly mortgage cost would rise by $567.79 a month or $6,813.48 a year.
But the bulk of that cost is deductible. After accounting for tax savings, the net cost of the loan is $4,900 a year, or roughly $147,000 over the life of the loan.
If they invested the $100,000 in stocks and earned an average of 7% over the same 30 years, they’d end up with $811,649. After subtracting 15% of the profit for capital gains taxes and the $149,000 net cost of the loan, this taxpayer is $557,902 ahead of the game.
“If you are young and can comfortably support a higher mortgage payment, the interest rate that you are paying on the loan is about 3 to 5 percentage points less than the presumed rate you’ll earn on your money,” said Mark Brown, a certified financial planner with Brown & Tedstrom in Denver. “That can amount to a lot of money.”
There are loads of caveats: The capital gains rules are set to expire in 2008. If not extended, rates would then rise to 20%, eating up an additional $35,582 in profit. And there’s no assurance that the rate won’t climb higher.
This strategy requires the ability to handle both the higher monthly mortgage payments and the risk that stock prices could plunge.
Brown says he advises against this idea for anyone with less than 10 years to invest. He also advises against it for anyone who can’t easily handle the additional monthly mortgage costs -- the last thing anyone should consider is putting their home at risk for an investment gamble, no matter how tax-favored it might be.
Times staff writer Kathy M. Kristof can be reached at firstname.lastname@example.org.