Investors must look at tax implications

Your Money

December 31, 2006|By Humberto Cruz | Humberto Cruz,Tribune Media Services

Most American investors favor what I've long considered a smart long-term strategy, investing in the stocks of companies that consistently increase their dividends.

But they do it without much understanding of the benefits, including superior compounded returns over time and a preferential tax rate.

That is one finding among many that emerged from a comprehensive survey by Eaton Vance Corp., a Boston-based investment management firm, underscoring a continued and major need for investor education.

As in previous years, the eighth annual Eaton Vance survey shows investors are still struggling to understand the tax implications of investing. I was struck by a lack of fundamental knowledge about tax-deferred plans that can cost investors dearly in unnecessary taxes.

For example, fewer than half of the 1,209 investors surveyed nationwide by the firm Penn, Schoen & Berland Associates understood that municipal bond funds and tax-managed stock mutual funds are most appropriate for accounts held outside tax-deferred qualified retirement plans.

That's because the interest from municipal bonds is free of taxes. But if a municipal bond fund were held in a tax-deferred retirement account such as a deductible individual retirement account, the interest would be taxed as ordinary income when the money is withdrawn. In essence, you'd be converting tax-free income into taxable income.

Tax-managed stock mutual funds, meanwhile, try to keep taxable distributions to a minimum. If you hold such a fund more than a year before selling it, gains would be taxed as long-term capital gains subject to a maximum 15 percent tax rate. But if you hold the fund as part of a deductible IRA, all gains on withdrawal would be taxed as ordinary income, subject to a higher tax rate of up to 35 percent.

In a similar finding, only 39 percent of investors said that tax-deferred variable annuities are most appropriate outside a qualified retirement plan, one subject to favorable tax treatment.

To be sure, annuity sellers contend that the insurance features of variable annuities, including the option to receive guaranteed lifetime income, make them appropriate for qualified plans and justify the additional insurance costs.

Every year since 1999, industry figures show most sales of variable annuities have been as part of qualified plans (to my mind because money being rolled over into IRAs from 401(k) and similar employer plans presents a juicy target for aggressive variable-annuity sellers).

But what many investors don't appear to realize - and this is the point of the Eaton Vance survey - is that using a variable annuity to fund a qualified retirement plan does not provide any tax deferral beyond that already offered by the plan itself.

Therefore, if your only goal is tax deferral and you don't care about the annuity insurance features, you'll do well to contribute the maximum to your qualified plans first before investing in a deferred variable annuity (if you invest in one at all).

Conclusion? "The need for better education about proper `asset location' is acute across all categories of investors," the Eaton Vance survey said. (Asset location refers to whether a particular type of asset is considered more appropriate for a taxable or tax-deferred account.)

And these are not investment novices - all investors in the survey are at least 25 years old and have a portfolio of at least $50,000, including 71 percent with more than $100,000 and one in seven with over $1 million.

Among this above-average group in terms of assets, a mere 3 percent knew that 64 percent of the historical return of stocks, as measured by the Standard & Poor's 500 index, has come from reinvested dividends. (Most thought the portion of returns attributed to dividends would be 33 percent or less.) Only 15 percent knew that, over the past 10 years, dividend-paying stocks have outperformed nondividend payers in the index.

Most surprising to me, despite the often acrimonious political debate since the tax rate for dividends was cut in 2003, just 30 percent of investors know that the top tax rate for qualifying stock dividend income is 15 percent. (Still, that's twice as many as got the answer right last year.)

Not knowing these benefits hasn't deterred investors from embracing dividend-paying stocks (58 percent of those surveyed say they invest in them). And nearly three times as many investors (45 percent) said they increased investment in dividend-paying stocks over the past three years compared with those who said they decreased such investments (16 percent).

Half of investors who increased investments in dividend-paying stocks said the reduction in tax rates in 2003 (good for them, they were aware of it) was at least a minor factor in their decision.

Humberto Cruz writes for Tribune Media Services.

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