Stocks and bonds, already enjoying a renaissance before tax reform was passed, now look even better.
That is because lower individual tax rates will let investors keep more of their profits. Tax-exempt municipal bonds also are given a boost because tax reform preserves them as one of the few remaining tax-sheltered investments available for the average investor.
"But just because taxes are less, you shouldn't let tax strategies dictate your investment strategies," said Larry Biehl, a financial planner in Menlo Park. Other factors, such as interest rates, inflation and the economy, will far outweigh tax rates in determining how well these investments perform, Biehl and other advisers say.
Here's a look at how tax reform affects stocks and bonds:
The cut in the maximum individual tax rate to 38.5% this year and 33% next year from 50% helps short-term stock investors. But the raising of the long-term capital gains tax to a maximum of 28% this year from 20% hurts investors who hold stocks for longer than six months, the period previously required to qualify for the capital gains tax.
However, at least for this year, you still will have a tax incentive to seek long-term capital gains. That is because this year the maximum capital gains rate of 28% still is lower than the maximum 38.5% rate on ordinary income.
Thus, securities bought before midyear can be sold by year-end for capital gains treatment. That could spur a year-end selloff of stocks similar to the one that hit the market at the end of last year.
Next year, however, long-term capital gains will be taxed the same as short-term profits, dividends and other so-called ordinary income. Thus, short-term traders will pay the same tax rates as long-term investors.
This change also will increase the lure of stocks paying high dividends, compared to growth stocks offering potential for high capital gains. Dividend-paying stocks tend to be more stable in price, and thus less risky, than growth stocks.
As a result, more companies are raising dividends to make their stocks more attractive. The number of dividend increases rose in December, January and February, reversing a long decline, said Arnold Kaufman, editor of the Standard & Poor's Outlook newsletter. He expects dividends on the stocks in S&P's 500-stock composite index to increase between 6% and 8% this year, compared to only a 4.8% increase last year.
Mutual fund categories offering high yields include growth and income funds, which invest mainly in stocks with a track record of increasing value and paying dividends; balanced funds, which invest in bonds and preferred stocks as well as common stocks, and income funds, which invest in dividend-paying common stocks as well as corporate and government bonds.
David Sargent, chairman of the investment committee of United Mutual Fund Selector, a Boston newsletter, recommends such growth and income funds as Evergreen Total Return (800-235-0064) and Strong Total Return (800-368-3863). Among income funds, he recommends Wellesley Income (800-662-7447) and Northeast Investors Trust (800-225-6704).
Not all experts, however, say conservative, dividend-oriented stocks are the best in today's market. Jay Schabacker, president of Schabacker Investment Management in Gaithersburg, Md., contends that the current bull market still has a lot of life. Thus, he recommends aggressive funds that emphasize stocks with high potential for capital gains, such as Fidelity OTC Portfolio (800-544-6666).
Rather pick stocks yourself? Lower corporate tax rates will help profits of such service-oriented industries as retailing, food, media, drugs and technology. Conversely, the repeal of the investment tax credit will hurt such capital-intensive industries as autos, steel, paper and chemicals.
However, stock prices to some extent already reflect these expectations, said Brian Fabbri, chief economist for Thomson McKinnon Securities. Some industrial stocks have been outperforming service-oriented issues of late, he noted.
Accordingly, experts say, you should pick stocks based on economic fundamentals, not tax considerations. "What happens with the economy, interest rates and corporate profits makes much more of a difference," Schabacker said.
Bonds also should be big winners under tax reform. Lower individual tax rates will let you keep more of your earnings from taxable bonds such as corporates and Treasuries. And while lower rates make the tax exemption on municipal bonds worth less, that is offset by the fact that tax reform preserves municipals as one of the few remaining tax shelters for the everyday investor.
If you're in this year's top tax bracket of 38.5%, a tax-exempt bond yielding 4.9% would be equivalent to a taxable bond yielding 8%. Tax-exempts issued in states with high state income taxes, such as California, can be even more valuable because their income is exempt from state tax as well. On the other hand, they tend to yield somewhat less to make up for that double advantage.