Do Not Base Investment Decisions on Tax Laws
Revised By: Elizabeth Silvestri, CFP^®
The Henssler Financial Group Position Paper

How many times, throughout the last 100 years, have changes in tax laws changed the way investors view particular investments? Tax-efficient investing relies on investment professionals to look at current tax laws and determine the most effective investment strategies.

With the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003, your financial planner, your tax consultant and your money managers must again re-evaluate investment types that are affected by the changes in this bill. This is the case each time a tax law is passed that affects investments, insurance, estate taxes, retirement plans, or any other element of a financial plan.

The Henssler Financial Group bases our overall approach to financial planning and investment decision-making not on tax law alone, but on a core of financial realities, empirical evidence and market history. The primary quality we look for in a stock being considered for inclusion in our model portfolio is the company's financial strength. Financially healthy companies are much less likely to be hurt in a recession, and are more likely to survive a depression. They are also usually in a better position to profit in a healthy economy. The primary quality we look for in fixed-income investments is safety. We stick to U.S. Treasury obligations or high-grade municipal bonds. Most municipal bonds are backed by a state's power to tax, while the U.S. Treasury prints money. In either case, principal is generally safe, or at least safer than in most other investments. Current tax laws are considered, however, that is not the primary reason to either own or not own an investment.

Do tax laws affect investment decisions? Of course. The suggestion here is not that tax laws should be ignored. Instead, tax laws should be considered, but not relied upon as the primary reason for making an investment.

For example, do you remember limited partnerships in the 1970s and early 1980s? High-income earners flocked to these investments to lower their tax bills, as the highest marginal tax bracket at the time exceeded 70%. Investors purchased shares of these partnerships with tax savings as the primary focus, because losses generated by the partnerships could be used to offset income received by the investor, thereby providing a higher after-tax cash flow. Then, in the mid 1980s, the tax laws changed and no longer allowed losses from partnerships to be used to offset earned income. Marginal tax rates dropped significantly as well. As a result, most limited partnerships lost a significant portion of their value, since their value was predicated on tax law. When the tax law changed, the investment lost value.

More recently, consideration is being given to either eliminating the estate tax law, or at least significantly increasing the amount of money someone can leave to heirs before the estate tax is applied. Many life insurance policies have been sold over the past few decades as protection from the estate tax — when the insured passes away, the insurance policy is designed to pay most or all of the estate taxes. But again, if the estate tax laws change or if estate taxes are eliminated entirely, this strategy could be thrown up in the air. Insurance policies should be re-evaluated on a somewhat regular basis to determine if the policy is still needed, and that the cash value, if any, achieved in the policy could not be put to better use elsewhere.

Now, with a 15% tax rate on both capital gains and stock dividends, different strategies are again being considered. Real Estate Investment Trusts (REITs) may not receive the 15% tax rate, as the income generated by them will still, in many cases, be taxed at regular income tax rates. This could hurt the valuation of some REITs. Again, our point is not to now avoid REITs as a result of the different tax treatment. REITs should be reviewed as any other stock would, for financial strength and potential growth, and not purchased simply for a high dividend. The recent tax law changes lowered the after-tax value of these higher dividends, as they may now be taxed at higher rates than dividends from most other stocks.

Additionally, retirement accounts such as 401(k) plans and SEP accounts lost a little luster in the recent tax bill. Funds contributed to these plans still are deducted against current income, which is a definite benefit. But now, while investments in stocks outside a plan generate dividends and capital gains that are taxed at 15%, growth inside a 401(k) plan is still taxed at regular income tax rates when the funds are eventually distributed. Of course, this could change in the future. We continue to recommend that investing in 401(k) plans, SEP plans and other retirement plans is good planning for your retirement. Although, this could change if tax laws further change; currently the tax-deferral and the current tax deductions on contributions are advantageous to you. Since these accounts have become primary savings vehicles for many Americans, it is unlikely that they would be made entirely unattractive by new tax law changes.

Tax laws are unavoidable — they must be considered when investment decisions are made. However, sound financial principles and the "basics" should still be the primary focus when making investment decisions. For more information regarding this topic, please contact The Henssler Financial Group at 770-429-9166 or comments@henssler.com.