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By Harvey Siegel, CPA, WS Securities Incorporated

There has long been controversy about the degree of attention to be paid to the imposition of taxes on investment returns. Maxims abound: "Taxes should never drive investment decisions" and "The certain way to minimize taxes is to eliminate profits." The premise is that an investor (or professional manager), unencumbered by tax considerations, will post net (of taxes) investment returns that will exceed those of a similarly talented investor (or manager) mindful of tax considerations.

On the other hand, there are those who assert that investment costs, including taxes, are the most significant factor in the determination of net investment return to the taxable investor. It should not surprise that adherents of the former are generally those whose financial products are actively managed, broadly marketed, and make no distinction as to the tax status of the investor. Proponents of the latter are generally those who have committed resources to creating specific products for the taxable investor.

Regardless of which side of the controversy a planner is on, the Taxpayer Relief Act of 1997 has increased the stakes for those who focus on gross investment returns rather than net returns to the taxable investor. The planner who seeks superior performance, hoping that marginal returns will more than cover the costs of taxes, runs the risk of compounding poor returns with a large tax liability. The planner who focuses on after-tax returns should, at worst, enjoy near market returns minimally impacted by the imposition of taxes.

Taxpayer Relief Act of 1997

Most important to the financial planner, however, is the act's capital gains tax relief for individual taxpayers. Previously an investor in the highest tax bracket was subject to a maximum tax rate of 28% on long-term capital gains. The act reduces the maximum tax on long term capital gains to 20%, almost doubling the differential between ordinary income tax rates (which remain at a maximum of 39.6% at the highest bracket) and capital gains tax rates from 11.6% to 19.6%. At the same time, the required holding period for capital gains was increased from 12 to 18 months.

In addition, there is a new capital gains tax rate of 10% for those in the 15% Federal tax bracket. It is unlikely that this provision will prove more than marginally useful, since an investor with capital gains of substance would quickly reach a higher tax bracket. The act further provides for a capital gains tax rate of 18% (8% for those in the 15% tax bracket), albeit with a minimum holding period of five years, available for investments purchased after December 31, 2000. A final provision relative to capital gains allows an investor to mark investments to market (and pay the tax) for purchases prior to December 31, 2000. These assets will then qualify for the 18% capital gains tax rate on realized appreciation subsequent to 2000.

Left untouched in the new law is the maximum 28% capital gains tax on investments held more than one year, yet less than the 18 months necessary to qualify for the 20% tax rate.

The Stronger Case for Capital Gains

The desirability of capital gains over ordinary income has always been an obvious objective for an investor in the higher tax brackets. In addition to enjoying a lower tax rate, holders of appreciated assets could defer their taxable gains indefinitely simply by not selling. Optimally, the owner of appreciated assets bequeathed them at death and thus escaped gains taxes entirely.

Capital gains relief has not changed the analysis relative to bequeathing appreciated assets or to the deferral of gains. However, the widened gap between ordinary income tax rates and capital gains tax rates dramatically increased the incentive to favor the latter over the former.

Where to Put Stocks Versus Bonds

For investors having both taxable accounts and tax-deferred accounts, where to place fixed income securities and where to place stocks has been controversial.

The case for stocks in the tax-deferred account, bonds in the taxable account:

* Assets having the most risk (stocks) should be placed in the vehicles with the longest investment horizon and, accordingly, the least likelihood of being called upon in a financial emergency (the retirement or tax-deferred account).

* Rebalancing a portfolio of stocks or stock mutual funds can be accomplished without generating any current tax liability if held in the tax-deferred account.

* A recent study by T. Rowe Price Associates compared the results of investing in a bond mutual fund and various types of stock mutual funds. Results were calculated for the bond fund in the taxable account, the stock fund in the tax-deferred account, and vice versa. The study used average historical fund performance provided by Morningstar. It presumed a 28% capital gains tax rate and various ordinary income tax rates. Importantly, the study presumed liquidation and payment of capital gains taxes at the end of the examined time frame. In general, the study showed that ending values were higher when the stock funds were placed in the tax-deferred accounts. The most important factor was time: the longer the investment period the better off an investor was by holding stock funds in the tax-deferred account and bonds in the taxable account.

* Many investors, although understanding the advantages of buying and holding stocks or stock funds in their taxable accounts, do not act accordingly. At best, the behavior results in recognizing gains more often than necessary; at worst, gains on stocks or stock funds are held for less than the required period and taxed at ordinary income tax rates.

The case for stocks in the taxable account, bonds in the tax-deferred account.

* Realized gains on stocks may qualify for capital gains tax rates that are substantially lower than the highest tax rates on ordinary income.

* If held in a taxable account, an investor can use realized losses to offset taxable gains. Losses in a tax-deferred account are not tax-deductible.

* Allocating stocks to the taxable account creates the opportunity for unrealized gains to escape income taxation entirely, so long as they remain unrealized at death. Gains on stocks held in tax-deferred accounts, whether realized or not, are always taxed at distribution.

The new lower rates on long-term capital gains have made the arguments in favor of stocks in the taxable account stronger as well as creating opportunities for the planner who is committed to taking an active role in maximizing after-tax returns for clients. The following suggestions to planners recognize the new

* Encourage clients to take a long-term view of their stock investments. Creating wealth in the stock market requires that you buy and hold.

* Examine with clients the likelihood or desirability of maintaining appreciated stock positions indefinitely. All the analyses favoring stocks in the tax-deferred account presume ultimate liquidation and the payment of taxes.

* Consider with clients the utilization of tax-managed mutual funds in taxable accounts. These are funds that, as a matter of investment policy, focus on after-tax returns by maintaining positions in appreciated securities, avoiding high-yielding stocks, and selling losing positions to offset gains. Some tax-managed funds specifically identify high cost shares when selling positions.

* Mutual funds that are naturally tax-efficient are index or market funds. The tax efficiency of these funds is due primarily to the nature of index fund investing. These funds' strategies are passive; that is, they are required to contain securities that match the objective index and to alter their balance of securities only when the underlying index undergoes a change. Generally, the turnover of indices has been small compared to actively managed stock funds, thereby allowing index type funds to defer most gains.

* Finally, although putting the investment or asset class with the highest expected return in the tax-deferred account is intuitively rational, time remains the most important factor in investing. Putting stocks in the tax-deferred account presumes that stocks will significantly outperform bonds during the period until withdrawal. Client's investment horizons should be evaluated relative to expected returns for stock and bond investments.

Variable Annuities

The increased differential between ordinary income tax rates and capital gains tax rates are significant relative to the desirability of investing in variable annuities.

Variable annuities are insurance products that offer, in effect, mutual fund investments in a tax deferred insurance wrapper. The insurance benefits are arguably modest, usually providing that heirs receive at least the original principal of the contract.

Generally, the contract owner can invest in a selection of mutual funds (subaccounts). Income and gains compound tax-deferred until withdrawal, when ordinary income tax rates apply.

The case for variable annuities:

* They provide insurance against investment declines. This may prove useful only if the contract owner dies shortly after purchase.

* There is tax-deferral of income and appreciation.

* A contract holder may rebalance asset classes or switch subaccounts without generating current taxable income.

* Although some contracts may specify a beginning date for withdrawals, unlike retirement accounts, current tax law does not require withdrawals during the lifetime of the annuity holder.

The case against variable annuities:

* Virtually identical mutual funds are available with or without the annuity insurance wrapper. If these funds were purchased outside the annuity, gains could be subject to tax at favorable capital gains rates rather than ordinary income tax rates. Similarly, a portion of capital gains taxes can be deferred indefinitely on funds held outside the annuity wrapper and even eliminated if they remain unrealized at death.

* Early withdrawal from a variable annuity (before age 59!s) is subject to a 10% tax penalty. (Contracts that are annuitized are not subject to the penalty tax.)

* There is no current tax deduction for losses on underlying annuity investments.

* Tax law does not recognize return of principal until all appreciation is withdrawn and taxed. (Once annuitization has begun, however, payments are prorated so that part of each is considered return of principal.)

* The costs of variable annuities can be high and are not always obvious.

* Most variable annuities are subject to surrender charges.

Traditionally, the case for variable annuities has been that over time the benefits of tax-deferred compounding overcame the differential in tax rates. The case presumed terminal liquidation and the payment of gains taxes on investments not held within the annuity. The case also presumed holding ordinary mutual funds with ordinary turnover and ordinary realization of capital gains on investments held outside the annuity.

The planner, after considering new tax rates and being knowledgeable of tax-efficient alternatives to ordinary mutual funds, would have reason to be cynical about ever realizing the projected benefits of investing within the variable annuity.

The Effect of Portfolio Turnover on After-Tax Returns

A recent study in the Journal of Investing calculated that a typical investor
experiencing 80% turnover in a portfolio (about 80% of stocks are sold and replaced annually), retained only 41% of the possible value of the portfolio after 25 years. The biggest share of the possible ending value, or 47%, went to taxes. The study presumed a tax rate on dividends of 36% and a capital gains tax rate of 28%.

The author concludes his article with a calculation suggesting that an actively managed investment portfolio (80% turnover), after investment expenses of 1%, would have to beat a tax-managed index fund by 2.63% annually to match the results of the tax-managed fund.

Whether the author's methods and statistical analyses are rational and consistent, this writer will leave to another. The author's premise, however, is incontestable. Lowering expenses, including taxes, increases return to the investor.

The increase in holding period from 12 to 18 months to qualify for the lower capital gains tax rate will certainly impact after-tax returns from strategies that are high turnover. All else remaining equal, a smaller portion of realized gains will be taxed at the lowest rate.

The arguments against low-turnover investment strategies focus on the ability of a skilled manager to compensate for increased taxes by generating superior pre-tax returns. ("Taxes shouldn't drive the investment process.") To achieve this goal, active managers must generate excess returns at least equal to the additional costs inherent in their style. In addition to higher taxes, these costs include higher management fees, higher commission charges, and the impact that buying and selling securities, often in large blocks, will have on market price.


Along with the great bull market that investors have experienced has come the institutionalization of individual investors through mutual fund and insurance company products. The sale is based on gross returns; costs and taxes are almost always ignored. Before marketing organizations controlled the process, investors were instinctively rational. Tax efficiency was intuitive; taxes, commissions, and fees were strong deterrents to pursuing inefficient strategies. Today, taxable, tax-deferred, and tax-exempt investors alike are urged to put their money at the discretion of the same manager, employing the same strategy, focusing only on top line returns. The Taxpayer Relief Act will be a test for the financial services industry. Clearly, given the increased and substantial advantage to long-term capital gains over ordinary income, the same mutual fund cannot be suitable for a taxable account, an IRA, and (as a clone) in a variable annuity.

As planners, we can add value by offering individualized service that does not rely upon generalizations and faulty conclusions. More than ever, for the taxable investor, specific situations require specific strategies. *


Deciding What Funds to Hold in Taxable vs. Tax-Deferred Accounts, published by T. Rowe Price Associates in the
T. Rowe Price Report, Issue No. 52, Summer 1996.

Garland, James P. "The Attraction of Tax-Managed Index Funds," The Journal of Investing, Volume 6 Number 1, Spring 1997, pp 13-20


By Martin D. Eisenstein, JD, CPA, Rosenzweig & Maffia LLP

The Tax Relief Act of 1997 provides a new opportunity for tax-free retirement savings. The act establishes IRC section 408A, which creates a new class of individual retirement account called the Roth IRA. The account is named after its proponent, Senator William V. Roth, Jr., R-Del., and should be of tremendous interest to personal financial planners.

A Roth IRA is called a "backloaded" IRA because no deduction is permitted for contribution to the Roth IRA, but a "qualified distribution" from the account is received completely tax free. A qualified distribution is one made under the usual IRA rules (after age 59!s or upon disability) as well as being made after the account has been maintained for five taxable years. If, however, a nonqualified distribution is made, the portion representing account earnings is taxable as income and subject to a 10% early withdrawal penalty, similar to the treatment accorded a regular IRA account. The Roth IRA is available to taxpayers filing joint returns with adjusted gross income under $150,000 and to single taxpayers with adjusted gross income under $95,000, whether or not taxpayer is an active participant in another retirement plan. There is a phaseout of eligibility from $150,000 to $160,000 for married taxpayers filing jointly and from $95,000 to $110,000 for single taxpayers. The Roth IRA contribution limit is $2,000 per spouse, which is the same as a the limit for a regular IRA under the new law. Any annual contribution made
for the year to a regular IRA reduces
the amount available that year to
fund a Roth IRA.

This opportunity to put savings in a vehicle from which distributions are received tax free is what makes the Roth IRA such a good thing. The Roth IRA is clearly superior to the current nondeductible IRA, which taxes distributions to the extent of account earnings. Taxpayers who cannot make deductible regular IRA contributions because their income exceeds the thresholds for individuals who are active participants of a qualified plan may want to take advantage of the Roth IRA.

Even taxpayers who are entitled to contribute to a deductible IRA should instead consider using a Roth IRA instead. A taxpayer in the 40% bracket can, if permitted, fund a $2,000 IRA contribution and achieve an $800 tax savings. But the taxpayer must pay tax at the "back end" when withdrawing from the account. Upon withdrawal, suppose the taxpayer is in the same 40% bracket. Each $2,000 withdrawal is subject to the same $800 reduction for taxes. In fact, with tax rates remaining at a constant rate of 40%, a Roth IRA of $1,200 per year gives the same after-tax yield as a regular IRA of $2,000 per year.

We know applicable tax rates rarely remain constant for taxpayers through the years. Traditional retirement planning assumes that taxpayers will be in a lower income tax bracket upon retiring than during their earning, IRA contributing years. Many practitioners have noticed that often, this is not the case. Also, inflation produced "bracket creep" pushes the tax on taxpayer income into higher marginal tax rates. Tax rates themselves have increased over the last 10 years since the low top rate of 28% and may yet increase further. If rates increase, a person receiving distributions from a Roth IRA will not be affected because distributions are received tax-free.

There are some caveats that need to be mentioned. Older taxpayers who want to avoid the five-year requirement before distributions can be made should consider using a regular IRA vehicle. Taxpayers whose special circumstances lead them to expect a significantly lower tax rate in retirement may want to avoid the Roth technique.

Roth IRAs can also be created by "converting" regular IRAs. A conversion is an amount distributed from a regular IRA and rolled over into a Roth IRA. If the taxpayer's AGI, including any amount converted, does not exceed $100,000, tax will be due on the converted amount, spread over a four-year period beginning in the year of conversion. If the conversion does in fact cause income to exceed $100,000, the full tax is immediately due, along with a 10% premature withdrawal penalty. Care should be taken to assure that any conversion follows the statutory rules. Conversion may be considered by a taxpayer who has a low-tax year in which to receive the conversion proceeds. Married taxpayers filing a separate return are ineligible for the conversion rules.

A final advantage to using a Roth IRA over a regular IRA is that contributions beyond the age of 70!s are permissible. Eligibility to fund a Roth IRA begins after December 31, 1997. *

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