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Wednesday, July 30, 1997
Budget deal's capital gains tax cut yet more good news to booming market
Two investments that might feel a pinch: annuities and tax-advantaged mutual funds
by Lloyd Chrein
Get ready for lower capital gains taxes. As part of the budget agreement forged Monday
night by the Clinton Administration and Congressional Republicans, the maximum rate on
profits from sales of investments will eventually fall to as low as 18%, and down to 8%
for those in lower income brackets.
The agreement, intended to balance the budget in five years and deliver the first federal
tax cut in 16 years, is expected to be passed by Congress this week.
Under the budget deal, the capital-gains rate will decrease from a maximum of 28% to 20%
for assets that are held for at least 18 months. The decrease is retroactive to include
assets sold after May 6, 1997. However, if you sold between May 6 and this Tuesday, you
only had to have held the asset for 12 months. The rate will dip to 18% for assets bought
after 2000 and held for at least five years.
The rate for joint income-tax filers earning less than $41,200 in 1998 will drop from 15%
to 10% on assets held for 18 months. That rate will drop to 8% in 2006 on assets held for
at least five years.
Economists say such a precipitous tumble in capital gains taxes will spark the already
supercharged economy, and will be particularly good news for the equity markets. But
don't expect an immediate market jolt.
"Some amount of boost has already been built into this market, because the market has
been going up for a long time and there's been plenty of talk about cutting capital gains
taxes," says Peter Kretzmer, senior economist at NationsBank Capital Markets. He adds
that the markets do, however, have some room to rise on the news, since analysts had been
expecting Republican lawmakers to lose more ground than they did on the capital gains
issue.
The effects will be most impressive in the long-term. Kretzmer says that smaller capital
gains tax payments will help companies by decreasing their cost of capital and increasing
their profits. It will also make it easier for firms to pass returns along to their
shareholders. In addition, investment projects that didn't pay off before will now have a
better chance, and companies that would
not have been formed before may now see the light of day.
"Entrepreneurs will be more likely to take the risk and form companies, adding to both
employment and income," says Kretzmer. "Overall, it's a good thing for the stock market."
Of course, not all the predictions are rosy. One school of thought shared by some
economists is that lowering capital gains taxes could ignite a selloff by those who have
been waiting for the rules to change. Yet the deal now on the table dampens that threat:
by raising the short-term classification from 12 to 18 months, it forces many investors
to hold assets for at least another six months to
get the 20% rate; those who want the 18% rate have to wait until 2006.
Some economists also argue that inflation could return and interest rates could rise as
investment opportunities improve and increased shareholder wealth translates into
increased consumption. "But that's a small-time effect, " says Kretzmer. "We already have
an investment boom going on in the United States. We have very strong capital spending by
firms, profits have been coming in very strong and the stock market's doing very well. If
anything, we've observed high interest rates relative to the low rate of
inflation."
With even more oomph in the stock market and less incentive to defer gains until
retirement, some analysts contend that a lower capital gains tax could steer investors
away from 401(k) plans and IRA's.
"It does mitigate to a certain extent the tax advantage of investing in 401(k)s and
various retirement vehicles," says Rick Allridge, a certified financial planner and head
of the Your Money investment area on America Online. "People will wonder whether they
should put money into their companies' 401(k) plans, where it's tax sheltered and there
are all sorts of restrictions, or just invest for the long
term in types of investment vehicles that they'd feel more comfortable with. The
differential between the after-tax returns on those two numbers becomes narrower."
Yet this doesn't mean you'd be wise to pull all your savings out of tax-deferred
retirement investments. Even without employer-matching contributions, which many
companies offer their workers, 401(k)'s will remain a good place to put your money.
"To the extent that all of your 401(k) contribution is taxed as ordinary income later on,
there may be some incentive to managing some of your money yourself and take the capital
gains hit," says Kretzmer. "But the tax-deferred nature of 401(k)'s is never going to be
outweighed by changes in the capital gains tax. When you put your money in a 401(k)
you're basically lowering taxes by much more because you're deferring them all the way to
retirement, and that's always going to be preferable to holding them in taxable forms of
investment and selling them in the shorter term."
A more likely casualty of the tax reduction will be various forms of annuities. According
to Allridge, "people are going to see less and less of a benefit when they evaluate the
hefty fees that they will be paying for the opportunity to invest in annuities versus the
tax savings available," he says. "If you were to just invest in equities, which many
annuities invest in anyway, the net effect is going to be
almost a wash. The tax savings from annuities may not justify the fees."
Lower capital gains taxes could also diminish the popularity of specialty mutual funds
aimed at reducing tax risk. While typical mutual funds buy and sell stocks in their
portfolios without much consideration of capital gains, so-called tax-advantaged or
tax-managed funds are managed to reduce such tax exposure. "There won't be as much of an
incentive to seek out these funds," says
Allridge.
Assuming the changes are signed into law, homeowners are likely to reap some of the best
benefits. Under the present deal, joint income-tax filers won't pay capital gains tax on
the first $500,000 in gains from the sale of a principal residence; single filers won't
pay on the first $250,000. The exclusion can only be used once every two years, and
applies to homes sold after May 6, 1997.
This will be a boon to anyone looking to retire and downsize, says N.Y.-based CFP Ronald
Roge. "Now you can take the money out of your home without the threat of a capital gains
tax and reinvest it in other vehicles, while improving your lifestyle," he says. "That's
hard to beat."
Web-formation
See what the capital gains tax cut will mean to your investments, with Money Online's
Capital Gains e-Valuator at:
http://money.com/features/capgains/
JW
abprosys@xxxxxxx
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