Updated: September 1, 2015
How can you take advantage of dividend and capital gain tax rates at historically low levels?
Sensible Financial™ identifies 4 specific strategies you can use to maximize your benefit.
The 2003 tax law1 reduced the tax rate on capital gains from 20% to 15%2. In addition, the treatment of dividends changes – once ordinary income, with tax rates as high as 39%, you now pay taxes on these returns at capital gains rates. This sounds like an unmitigated benefit. Who doesn’t like to pay less in taxes?
The mitigation is that these benefits are scheduled to last only five years or so, terminating December 31, 2008. Sensible Financial knows of no way to predict whether they will continue beyond that date or not. However, we’ve designed the advice below to be effective even if the reductions don’t continue.
How can you take the fullest advantage of reduced tax rates? Aside, that is, from smiling a bit when you file your 1040 next April, as you say to yourself, “I saved $100 (or pick your number) because tax rates are historically low.”
Not surprisingly, the actions we recommend have to do with moving assets into situations where their earnings pay taxes at the lower rate. And, that requires moving them out of other investments where the costs are now relatively higher.
“Buy and hold” and “value” investing strategies are more attractive for your taxable accounts
- Buy and hold. Long term capital gains are now relatively even more valuable than short term gains in taxable accounts. A dollar of long-term capital gains is worth 85¢ after tax (the only dollars you can spend) in a taxable account3, while a short-term capital gain dollar is worth only 75¢ (if you are in the 25% bracket) or even 65¢ (in the 35% bracket). So, waiting until your capital gains have their first birthday, and become “long-term” makes even more sense than it did before.
Active trading tends to produce short-term gains and losses. If you must trade, trade in your tax-deferred accounts. Incidentally, managed mutual funds that trade a lot (and take a lot of short term capital gains) are relatively less attractive now – their tax efficiency will be even worse relative to index funds.
- Emphasize “value” equities. “Value” stocks have low P/E or price to earnings ratios, and they tend to pay dividends. Dividends are significantly more valuable now – you can keep 85¢ of every dollar now, versus 75¢ before (if you are in the 25% bracket) or even 65¢ (in the 35% bracket). Plus, you keep 85% of the capital gains, versus only 80% before. As a result, your after tax rate of return on value stocks is likely to be much higher now than before (6.6% vs 5.2% for value stocks with 6 percentage points of the expected 8% return from dividends).
In contrast, “growth” equities’ values depend more on the expected growth of the underlying companies. Your rate of return on these stocks (and if you are a Sensible Financial client, growth index mutual funds) doesn’t change in taxable accounts, staying at 7.1%.
The advantages of “tax-advantaged vehicles” are less
If taxes are less, then so are tax advantages. In some cases, the “tax advantages” actually have become negative. And, for some “tax-advantaged” vehicles charging extra fees, the fees have become much more likely to swamp the “tax advantages”.
- Reconsider how much you should be contributing to non-deductible IRAs. Non-deductible IRAs allow the tax-deferred accumulation of investment returns. However, the investment returns are ultimately taxed at ordinary income rates. The advice here is a little bit complicated. For most of the advice, we’ll assume that you expect your tax rate to be the same after you retire as it is now, or even lower.
- If you intend to hold only fixed income assets in the non-deductible IRA, go for it. This is pure tax deferral, in effect earning investment returns on your taxes before you finally have to pay them. REITs (Real Estate Investment Trusts – vehicles for investing in commercial real estate) should be thought of as fixed income assets in this context – their dividends are treated as “interest” for income tax purposes.
- If you intend to hold “growth” equities in the non-deductible IRA, don’t do it. Even for the longest time horizons, you end up with more spending power paying low capital gains taxes in the future rather than higher ordinary income taxes.
- For “value” equities, the decision depends upon your time horizon. If you will be holding the investment for more than 10 years or so, the benefit of tax deferral outweighs the lower tax rate you pay on dividends versus ordinary income and you should use the non-deductible IRA. If your time horizon is short, the reverse is true — you should stick with an ordinary taxable investment account4.
- If you expect your tax rate to go up after you retire, don’t invest in a non-deductible IRA. In this case, deferring taxes means avoiding low taxes now, waiting until later when you can pay high taxes. Not a good idea before, not a good idea now.
- Think three times, not twice, when offered the opportunity to buy a variable annuity (or VA)5. VAs are a favorite offering of securities brokers and insurance agents as vehicles for investing in equities while deferring taxes . Their potential advantage for clients is that they can be used to defer taxes6. Their advantage (not potential) to the brokers and agents is the very significant commission that they typically carry. In fact, they function very much like a non-deductible IRA with extra expenses.
In the tax rate environment that was in force until the passage of the new tax law, a VA was most likely to deliver on its promised tax savings for someone whose tax bracket after retirement was lower than before retirement, and who invested in higher yielding securities7. VA earnings are ultimately taxed at ordinary income rates. Since dividends were also taxed at ordinary income rates (39.6% in the example), deferring taxes on dividends was always an advantage. On the other hand, capital gains were taxed at lower rates (20% for most people who had enough spare cash to be attractive targets for brokers and agents). If you expected to retire in a high bracket under the old tax laws, putting off capital gains tax rates to pay ordinary income tax rates was already not such a great idea. In fact, as the graph shows, for investments with low yields (and high capital gains), buyers of VAs with high post-retirement tax rates, actually paid more taxes than non-buyers (the zones labeled in pink, beige and red).
With the new, lower tax rates on capital gains, and especially, on dividends, buyers never realize the potential advantage. Basically, the new tax law has eliminated the advantages of tax deferral – putting off the low tax rates on capital gains and dividends in order to pay higher ordinary income tax rates later is a money-losing idea.
The economics of your mortgage have changed ever so slightly
Your new tax rate is probably slightly lower than previously. As the following chart illustrates, rates have declined by 2 or 3 percentage points, depending on your taxable income. If you have a mortgage, this means that your after-tax cost of borrowing has gone up slightly. If your mortgage interest rate is 6%, your after-tax rate is now .12% to .18% higher. If your mortgage interest rate is 5%, your after-tax rate is now .10% to .15% higher.
For example, if you were in the 27% bracket, and are now in the 25% bracket, your 6% mortgage was costing you 4.38% after-tax, and now costs 4.5% after-tax.
Compare this to the after-tax economics of investing in equities that we mentioned above, where expected investment returns on growth equities are unchanged at around 7%, and expected returns on value equities have improved from 5.2% to 6.6%.
You may have heard that paying of your mortgage gives you a guaranteed return, and it does. Your return is the after-tax interest rate. The tradeoff has changed: paying off your mortgage is now a slightly better deal, investing in value equities after tax is now a significantly better deal.
The implications for you of this tax rate environment depend on many factors, and it may be worth thinking through your options. Sensible Financial is ready to help. Give us a call if you’d like assistance in creating a solid plan of action.