Appraise Your Tax-Influenced Accounts

Physician's Money Digest, June15 2004, Volume 11, Issue 11

The recent revamping of the taxcode may have some ripple effectson investing for retirement, andsome established investing guidelines maynow need to be reviewed and reevaluated.

Tax Cut Consequences

The latest round of tax cuts has someexperts debating whether investors shouldstill hold dividend-paying stocks in tax-deferredaccounts. The assumption hasbeen that investors can use these accountsto avoid taxes now and then pay themwhen they take withdrawals in retirement—presumably at a lower tax rate.

But now the tax rate on dividends andlong-term capital gains is down to 15%, formany taxpayers. Does it make sense, then,to keep stocks in a tax-deferred accountonly to have dividends and capital gainstaxed at ordinary rates as high as 35%when you withdraw them?

Interestingly, a top tax bracket of 35% isquite low by historical standards, and thereis no guarantee that taxes won't increase.With mounting deficits, legislators may beforced to increase taxes between now andthe time you tap your tax-deferred accounts.If so, it is possible that rather thanbeing in a lower bracket, you could actuallybe in a higher bracket than you are innow once distribution time comes around.

Investment Concerns

Another important factor to considerwhen making investment decisions is howtaxes can affect your investments. Investorshave generally been advised to put investmentsthat regularly pay taxable interestand dividends into their tax-deferred accountsrather than their taxable accounts.But with the changes in the tax code, youmay now want to reevaluate your decisions.When the government taxes youraccount annually, you're left with lessmoney to compound. The after-tax rate ofreturn illustrates this point. If an investmentpays 5% interest annually, you mustpay ordinary income tax on that amount,leaving you with an after-tax return of3.75% on that investment. If a stock annuallypays a 5% dividend that qualifies forthe reduced rates, you will owe only 15%tax, leaving an after-tax return of 4.2%.But if you hold either of these investmentsin a tax-deferred account, you would havethe full 5% working for you.

However, the dividend rate cuts end in2008, and dividends will again be taxed asordinary income starting in 2009. Likewise,in 2009, long-term capital gains will goback to being taxed at 10% for taxpayersin the 10% and 15% tax brackets and at20% for those in higher brackets.

Some experts contend that investorsshould have a 5-year investment time horizonfor stocks. Thus, you should ask yourselfif it is worth making adjustments toyour investments to capitalize on benefitsthat are scheduled to expire in 6 years. Onthe other hand, if you change your strategynow and legislators decide to extendthe current rates, you could be in a greatposition to reap the rewards. Your financialconsultant and tax advisor can help yousort through the choices and make the bestdecisions for your financial situation.

Joseph F. Lagowski is vice president,investments, and a financialconsultant with AG Edwards inHillsborough, NJ. He welcomesquestions or comments at 800-288-0901 or This article was providedby AG Edwards & Sons, Inc, member SIPC.