Consider sunset provisions before shifting investment

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Changes to the tax code may have some ripple effects on investing for retirement, and some established investing guidelines may need to be reviewed and re-evaluated. |ret||ret||tab|

The latest round of tax cuts has some experts debating whether investors should still hold dividend-paying stocks in tax-deferred accounts. With the increased availability of 401(k)s, traditional individual retirement accounts and tax-deferred annuities, investors have access to many vehicles that help delay paying taxes on their retirement savings. |ret||ret||tab|

The assumption has long been that investors can use these accounts to avoid taxes now and then pay them when they take withdrawals in retirement, presumably at a lower tax rate. |ret||ret||tab|

But now that the tax rate on dividends and long-term capital gains is down to 15 percent for many taxpayers (5 percent for those in the 10 percent and 15 percent ordinary tax brackets), does it make sense to keep stocks in a tax-deferred account only to have dividends and capital gains taxed at ordinary rates as high as 35 percent when you withdraw them? |ret||ret||tab|

Interestingly, a top tax bracket of 35 percent is quite low by historical standards (it has been as high as 90 percent) and there is no guarantee that taxes won't increase. |ret||ret||tab|

With mounting decits, legislators may be forced to increase taxes between now and the time you tap your tax-deferred accounts. If so, it is possible that you could actually be in a higher bracket than you are in now, once distribution time comes around. |ret||ret||tab|

Another important factor to consider is how taxes can affect your investments. Investors have generally been advised to put investments that regularly pay taxable interest and dividends into their tax-deferred accounts rather than their table accounts, but with the changes in the tax code, you may want to re-evaluate your decisions. The logic here is straightforward. When the government taxes your account annually, you're left with less money to compound, which may reduce the balance in the account when you need it. |ret||ret||tab|

To illustrate this point, start with a simple concept: after-tax rate of return. If an investment pays 5 percent interest annually, you must pay ordinary income tax (let's assume it's 25 percent) on that amount, leaving you with an after-tax return of 3.75 percent on that investment. If a stock annually pays a 5 percent dividend that qualies for the reduced rates, you will owe only 15 percent tax, leaving an after-tax return of 4.25 percent. But if you held either of these investments in a tax-deferred account, you would have the full 5 percent working for you. |ret||ret||tab|

When you consider whether you should shift the allocation of your investments among your taxable and tax-deferred accounts, bear in mind the tax cut legislation's sunset provisions, which dictate when different portions of the law expire. |ret||ret||tab|

The dividend rate cuts sunset in 2008 and dividends will again be taxed as ordinary income starting in 2009. Likewise in 2009, long-term capital gains will go back to being taxed at 10 percent for taxpayers in the 10 percent and 15 percent brackets, and at 20 percent for those in higher tax brackets. |ret||ret||tab|

While 2009 may seem a long way off, it really isn't when it comes to investing. Some experts contend that investors should have a ve-year investment time horizon for stocks. With this in mind, you should ask yourself if it is worth making major strategic adjustments to your investments to capitalize on benets that will expire in that amount of time. On the other hand, if you change your strategy now and legislators decide to extend the current rates, you could be in a great position to reap the rewards. Your nancial consultant and tax advisor can help you sort through the choices and make the best decisions for your nancial solution. A.G. Edwards does not render legal, accounting or tax preparation advice. You should consult your tax and legal advisors for your specic situation. |ret||ret||tab|

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Timothy Reese is senior vice president, investments, with A.G. Edwards & Sons Inc.|ret||ret||tab|

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