Assume you're a retiree who needs steady, dependable investment income, or you're a younger person who wants some traditional "fixed-income" holdings such as bonds.
How should you place your bets to benefit most from the new tax law approved late last month?
Put simply, you'll have to rethink your priorities -- and probably take on more risk.
Retirees, for instance, won't be able to get the biggest bang out of the new rules unless they move money out of bonds and into stocks. And if they are to get the highest possible income in retirement, they may have to give up the widely held belief they should never spend principal.
Life on a fixed income seems to get scarier and scarier.
How can this be?
Because the rules boil down to this: Any investment that pays interest becomes less desirable, while those that pay dividends or enjoy long-term capital gains become more desirable.
Hence, stocks become more attractive. Bonds, certificates of deposit and money market funds -- the traditional safe havens for older investors -- are less appealing.
Under the old rules, interest and dividend income were taxed at income-tax rates as high as 38.6 percent. With the new rules, already in effect, interest is still taxed as income, though the top rate has fallen to 35 percent. Most investors will pay even less -- 25, 28 or 33 percent.
But dividends are no longer taxed at income-tax rates. Instead, they are taxed at the same rate as long-term capital gains -- the rate on investments owned longer than a year. Moreover, that rate was cut to 15 percent from 20 percent.
Bottom line for income-oriented investors: The tax bill on a dividend paid on a stock may be just half what it is on interest from a bond, bank CD or money market fund.
The problem, of course, is that stocks are generally riskier. The price of the stock might fall, while a government-insured CD or a money market fund is very safe. Government bonds, and many corporate bonds, can be very safe as well, especially if you intend to hold them to maturity. (If you sell before maturity, any profit will be taxed at the capital gains rate.)
Fixed-income investors face a double whammy. They're lucky if they make more than 2 or 3 percent on their bonds, CDs and money market funds. Second, the tax on that paltry earning will be substantially higher than on other investments.
Make it a triple whammy, since some investments that would seem to benefit from the dividend tax cut actually do not:
l Preferred stocks. These often pay larger dividends than ordinary stocks do, making them especially attractive to fixed-income investors. They are "preferred" because their promised dividends must be paid before dividends can be paid on ordinary, "common" shares.
I won't get into all the complex ins and outs of preferreds here. The important point is that dividends paid by most preferreds will continue to be taxed as income, at those 25-35 percent rates. That's because, in most cases, preferred dividends are really interest payments, so they won't enjoy the 15 percent rate for ordinary dividends.
l Real Estate Investment Trusts. REITS are like mutual funds that invest in commercial and residential properties. Fixed-income investors like them because they must pass on to shareholders at least 90 percent of the annual income they derive from such sources as rent. And many are quite generous, paying 7, 8 or 9 percent -- though share prices move up and down like stocks.
Unfortunately, REIT income will continue to be taxed at income-tax rates rather than dividend rates. This is because REIT income is tax-exempt at the corporate level. Dividends from ordinary corporations are getting a tax reduction because the corporation must pay tax on that money as well.
l Municipal bonds. There's no change in the tax treatment of munis -- their interest payments continue to be exempt from federal tax. This has long made munis attractive to fixed-income investors, especially those in high tax brackets. However, the relative benefits of munis are reduced slightly because tax rates on competing investments have been cut. Investors will have to figure which investments will leave them with the most after all taxes have been taken into account.
For young investors, the new tax rules are a great deal. These folks have long been advised to emphasize stocks. Since they have time to weather stock-market downturns, they can enjoy the larger returns stocks average over long periods. Now these investors also can benefit from lower tax rates on dividends and capital gains.
Older investors who need to emphasize short-term safety aren't as fortunate. With fixed-income investments paying so little, and with the relatively high tax rates on this kind of income, many people will have no choice but to shift money to riskier stocks or stock funds in hopes of earning higher after-tax returns.
For many, the first impulse will be to look for safe dividend-paying stocks such as utilities. But they shouldn't overlook stocks that don't pay dividends. There's really nothing wrong with selling shares -- that is, your principal -- to generate income.
After all, if you invested $100,000 in stocks that grew to $105,000 in a year, you could sell $5,000 worth of shares and still have $100,000 in shares. If you had $100,000 in bonds paying 5 percent, you'd have $5,000 in income and $100,000 in bonds after a year. Either way, it's the same.
Of course, you can't get 5 percent on a bond these days. Even if you did, the tax on your bond income under the new law might be twice what you'd pay on the same income if it came from stocks.