Tax law changes call for financial planning Dramatic overhaul includes cuts in capital gains

January 18, 1998|By Mary Beth Regan | Mary Beth Regan,SPECIAL TO THE SUN

When Congress finally hammered out a deal to balance the federal budget by 2002, Republicans and Democrats, eager to sweeten the sell to the public, threw in $152 billion in tax cuts over the same period, enough for both parties to claim bragging rights.

The result: "These are the most dramatic changes we've seen since '86," said Arthur E. Flach, tax partner in Grant Thornton's Baltimore office.

For the investor, the tax overhaul means financial planning may be in order. In all, the Taxpayer Relief Act of 1997 contains more than 100 provisions that jiggers the rules affecting everything from IRAs to estate taxes to capital-gains taxes to college tuition benefits.

Still, the law is cumbersome, so plot your course carefully. "It's not easy going," cautioned Dennis M. Gurtz, a financial planner with American Express Financial Advisers Inc. in Bethesda.

One feature that will affect millions of American families: a new $400 ($500 in 1999) tax credit for each child 17 and under. Families will an adjusted gross income up to $110,000 ($75,000 for singles) will get the full benefit. Unlike the exemption a family gets for each dependent ( $2,700 for 1998), the $400 credit per child comes right off the amount of taxes owed.

Another change grabbing headlines is the reduction in taxes on long-term capital gains. And for good reason. The impact will be enormous. The top capital-gains rate drops to 20 percent for long-term investments, down from 28 percent in 1997. But beware: Long-term investments are those held for 18 months, not a year as under the old law. For individuals earning less than $24,650, or couples earning less than $41,200, the rate drops to 10 percent. Financial planners expect a flurry of people to cash out gains on overvalued stocks, in order to pump proceeds back into better buys.

Because of the change, you may want to reconsider whether to put high-growth investments into tax-deferred accounts, such as IRAs. The reason: You'll want your money taxed at the lowest rate when you begin drawing money out. Distributions from tax-deferred accounts are taxed as ordinary income -- which could be as high as 39.5 percent under current rate schedules. But long-term capital gains from a portfolio of stocks and mutual funds would be taxed at a 20-percent maximum. "Some people might be better off with money in the stock market," says Flach. But run the numbers: An analysis by T. Rowe Price Associates Inc. shows an individual in the 28 percent tax bracket coming out ahead in a tax-deferred plan.

Rules on profits for a home sale are another possible bonanza. "This offers tremendous opportunities," said Christine Fahlund, a Rowe Price financial planner. Under the old law, you could defer taxes on profits from your home sale -- if you pumped the money back into a residence of equal or greater value. Or individuals 55 and older could claim a one-time exclusion of up to $125,000. Now anyone can cash in tax free -- up to $250,000 for singles or $500,000 for couples in home profits. One catch: You must live in the house for two of the previous five years. But you can use the exemption every two years.

For the ambitious, that means you could rehab houses and sell them with tax-free profits every two years. Or, Fahlund pointed out, retirees could pocket the gain on a vacation home by moving into it for two years to establish residency. "But the catch is, your property has to appreciate," Fahlund warned.

For families more concerned about sending children to college than selling second homes, the law has a few goodies too. For starters, a new nondeductible education savings account -- contributions are in after-tax dollars -- lets you stash away $500 per child until a dependent is 18. When money is withdrawn for tuition and housing, the earnings are tax-free. The qualifying cap $95,000 adjusted gross income for singles and $150,000 for couples.

But don't despair: If you're a two-income family pulling down more than $150,000, have a qualifying relative -- say, grandma -- put $500 into your child's account each year. And if your eldest decides to open a bagel franchise instead of enrolling in college, you can transfer the money to a sibling's account. But you'll have use the funds by the time the child is 30, or face a 10 percent penalty.

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