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.
