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Post-JGTRRA investment management strategies.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) was the third major piece of tax legislation enacted in the past three years and one of the shortest tax acts in recent history (just under 25 pages). Despite its length, it delivers monumental planning strategies for clients.


From an investment management perspective, the JGTRRA's major provisions are as follows:

1. Ordinary income rate reduction. The JGTRRA reduced the four top income tax rates for individuals, estates and trusts, from 2003-2010:
From To Decline

38.6% 35% 9.3%
35% 33% 5.7%
30% 28% 6.7%
27% 25% 7.4%

2. Capital gain rate reduction. The JGTRRA reduced the top long-term capital gain rate for most individuals, estates and trusts from 20% to 15% for sales after May 5, 2003, a 25% decrease.

3. "Qualified dividend income" category. The JGTRRA created a new category of investment income--"qualified dividend income," which is taxed to most individuals, estates and trusts at a 15% rate, effective Jan. 1, 2003. Pre-JGTRRA dividends had been taxed at the ordinary income rate. The reduction in the tax rate represents a 61% rate decline for most taxpayers.

The lower dividend and capital gain rates are scheduled to expire after 2008, creating more planning opportunities. Tax-efficient investing is a priority for clients; it is not how much they earn that matters, but how much they get to keep.

Building an Investment Plan

Just because dividend income may be more advantageous from a tax perspective than interest income, not all clients should automatically be shifted to equity portfolios. An adviser must first understand a client's needs and expectations for the portfolio, beginning with goals and objectives. The adviser must then assess the client's tolerance for risk and volatility, and need for portfolio income and appreciation. Finally, the adviser should consider the asset allocation most appropriate to meet the client's needs.

Exception: Not all portfolios will be affected by the JGTRRA; some investment clients have no tolerance for volatility and no need for additional income or growth. Due to their aversion to volatility, their portfolios will usually be heavily invested in insured municipal bonds. Even with the JGTRRA's reduction in the ordinary income tax rates, municipal bond income still makes sense for many of these investors. There are also growth-oriented clients with portfolios already heavily allocated towards equities.

Assessing a portfolio: The asset-allocation strategies that most need review are those that are relatively balanced (i.e., anywhere from 70% equities and 30% fixed income to 30% equities and 70% fixed income). Among the factors to consider in assessing a portfolio are:

* Bonds have rallied during the recent bear market; as a result, interest rates are at historically low levels.

* Stocks seem to be emerging from the worst bear market in decades; after the JGTRRA, many companies are increasing their dividend payouts.

The portfolios most adaptable to change are those with both taxable and tax-deferred accounts. The JGTRRA would dictate shifting fixed income to tax-deferred accounts and equities to taxable accounts. Often, the result will be to concentrate individual accounts in one asset class, but the overall portfolio will still be balanced.

For clients in balanced portfolios (e.g., 50% equities and 50% fixed income), advisers should consider a shift to perhaps 55% or 60% equities. This does not require a significant shift in the client's risk and volatility tolerance. Bond prices are currently very high; it is unlikely that they will stay at this level over the next five to 10 years. As a result, advisers might shift assets from fixed income to dividend-yielding blue-chip stocks.

Example: At press time, General Electric Co. (GE) stock was trading at $28.28 per share, with a 2.65% dividend yield. GE bonds are AAA-rated; a 10-year bond at par is currently yielding 4.9%. Clearly, if an investor buys a 10-year GE bond and holds it to maturity (barring default), her or she will receive a 4.9% return. Assuming a 35% tax rate on interest income, the after-tax rate of return is 3.185%. The risks inherent in owning this bond include default and interest-rate risk.

Alternatively, if an investor buys GE stock today, he or she can anticipate a 2.65% current dividend yield. Naturally, there are risks in owning this stock, such as investment risk (i.e., the stock declines in value) and the risk that the dividend could be reduced or eliminated. An adviser should consider the following issues in evaluating all of the risks of owning the stock or the bond and discussing them with a client:

* The dividend will be taxed at 15%.

* The interest will be taxed at ordinary income tax rates (potentially as high as 35%).

* The dividend growth rate for GE has been nearly 15% annually for the past 10 years.

* The total return for GE is 16.4% over the past 10 years (mostly from its dividends).

These principles apply to many dividend-yielding blue-chip stocks.

Volatility vs. risk: Another issue is the difference between volatility and risk. Volatility is the likelihood that a stock will fluctuate in price. A more volatile stock will obviously have a greater swing in price. In a portfolio, using asset-allocation principles, volatility can be measured, monitored and controlled.

However, there is a difference in volatility between dividend-paying and non-dividend-paying stocks. According to Ned Davis Research, during the four-year period ended Dec. 31, 2002, dividend-paying stocks' total return declined approximately 22%, while non-dividend payers fell 63%.

Unlike volatility, risk can be measured and monitored, but not readily controlled; it is more likely mitigated through diversification.

Refocusing on Dividends

The economy is entering into a period in which companies have an increased willingness and ability to pay and/or increase dividends. For example, Citigroup increased its dividend by 95% over the past year; many other companies have also recorded double-digit increases in their dividends. Studies show that approximately 50% of stock returns can be traced to reinvested dividends. It can be argued that a large part of the renewed emphasis on dividends is due to the passage of the JGTRRA, which places dividends on the same level as appreciation and on a higher level than interest income.


The JGTRRA's passage means favorable tax treatment for dividends. Advisers may need to restrategize asset allocations for clients. Individuals can only guess what will happen to rates after 2008 (or even earlier); until then, the tax cuts, when coupled with low-yielding bonds and a resurgent stock market, offer an excellent opportunity to improve an investment portfolio's after-tax performance.


Robert K. Doyle, CPA/PFS Shareholder

Spoor, Doyle & Associates, PA St. Petersburg, FL
COPYRIGHT 2004 American Institute of CPA's
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Title Annotation:Jobs and Growth Tax Relief Reconciliation Act of 2003
Author:Doyle, Robert K.
Publication:The Tax Adviser
Date:Jan 1, 2004
Previous Article:Significant recent developments.
Next Article:Joint audit planning process.

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