Throughout the last 100 years, how many times 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 American Taxpayer Relief Act of 2012, 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.
Henssler Financial 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.
Consideration has been 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 maximum 20% tax rate on both capital gains and stock dividends, different strategies are again being considered. Real Estate Investment Trusts (REITs) may not receive the 20% 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. 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 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 a maximum 20%, 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. 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, contact Henssler Financial at 770-429-9166 or experts@henssler.com.
Disclosures:
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
