WILMETTE, ILL. — "BUY!" "SELL!" "HOLD!" - the old cries of investing - should today include a new refrain: "SCRATCH YOUR HEAD!"
The $95 billion tax reduction recently enacted by Congress cuts Uncle Sam's take from investment windfalls. But it also makes the process more complex.
The size of an investor's after-tax bonus now varies more than before, and it depends on gross income and how long the investment is held.
The top tax rate on long-term capital gains - the profit you make from investments - has fallen from 28 percent to 20 percent. And for investors in the 15 percent income-tax bracket, gains are taxed at 10 percent instead of 15 percent.
Despite the boost for investors of modest means, the new law sends most of its benefits to two groups of investors: those who are wealthy and those who take the buy-and-hold approach so often recommended by financial advisers.
Short term now short-sighted
Run-and-gun investors who take "short-term" gains - selling assets before 18 months are up - still face the higher tax rate of ordinary income.
"The tax on short-term gains hasn't changed, so is someone with a huge profit going to wait 18 months to lock in a lower capital-gains tax? Probably not," says Dale Reporto, an investor at a Fidelity Investments branch office in Wilmette, Ill.
Tax and investment pros say the new law's effect on the stock market will range from moderate to slight. Some expect investors to sell and lock in profits at the lower tax rate. But most analysts believe the new law won't jolt the market either way in the short term.
Stock up on equities
Over time, however, the picture changes. The tax law will likely spur the purchase of equities, because long-term capital gains are taxed less than the income from bonds, certificates of deposit, savings, and other fixed-income investments, experts say.
"I don't think there will be major changes," says Joan Blum, senior vice president at Fidelity in Boston.
"There will be some tendency for people to take a little bit longer horizon ... and people may be more sensitive to the different tax treatment for dividends and capital appreciation," she says.
"We will see strategies and financial products evolve to generate capital gains and work away from income," predicts David Cohen a personal finance specialist at KPMG Peat Marwick in Chicago.
Indeed, investment advisers today urge clients to buy, and hold, growth stocks with no or low dividends. When sold, they are taxed at the low capital-gains rate. In turn, they recommend paring back bonds and stocks with high dividends, since their yields are taxed as ordinary income.
Experts also recommend keeping a closer eye on the tax impact of mutual fund management style.
"Low-turnover" managers - who trade less than 20 percent of their portfolios each year - often outperform high-turnover managers even before taxes, says Morningstar, the Chicago fund tracker.
Low-turnover US stock funds gained 27 percent for the year ending June 30, versus 17.5 percent for funds with turnover above 100 percent. For the past decade, buy-and-hold funds beat itchy-fingered ones by 1.6 percentage points a year.
The new tax law favors that strategy, since low-turnover funds generate profits taxed at the new, lower rate.
The tax changes are unlikely to sink in until late this year, when investors weigh their 1997 returns against their mutual fund strategies, say tax experts.
Investors at a Fidelity Investments office here say they plan few strategy shifts.
"My husband and I just buy stocks. We tend not to sell them much, so the new law doesn't make that much difference," says Carol Hughes of Chicago.
"Anything that takes the bite out of taxes is great, but I'm strictly a buy-and-hold investor, so I won't change my strategy much beyond maybe putting a bit more into growth stocks rather than bonds and income-oriented stocks," Mr. Reporto says.
"Taxes are a piece of puzzle but not the major piece. Our investors tend to follow long-term strategies," says Greg Gable of Charles Schwab in San Francisco.
Financial advisers say the new tax law favors:
* Stocks of "growth" companies that pay no or low dividends (which are taxed as ordinary income). Your earnings will be low-taxed capital gains.
* Less-frequent trading. Investors should heed the 18-month duration or get slapped with higher taxes.
* Low-turnover mutual funds, such as index funds or funds run by buy-and hold managers. Look for a "turnover ratio," or the percentage of the portfolio annually traded, well below the typical 90 percent level.
* Selling just before a stock or mutual fund declares a dividend. The value of the dividend will be priced into the shares, so you effectively treat the payout as a capital gain rather than as higher-taxed income. A broker or fund representative can indicate the date of planned dividends, called the "ex-dividend" date.
* Taxable rather than tax-deferred accounts for some investors. Earnings from individual retirement accounts, 401(k)s, and other retirement savings are taxed at the high rate of ordinary income when you withdraw them. So investors in the highest tax bracket of 39.6 percent and those who plan to draw on their retirement savings within 10 years should consider putting their money into taxable accounts.
* Selling laggard investments to offset short-term capital gains or other income. Previously, tax experts told clients to sell loser stocks to lighten the tax burden on both short- and long-term capital gains. But today, the dogs in a portfolio go further in offsetting short-term gains, since they are taxed higher than long-term gains.
A Longer Term, but Shorter Tax
Here's the nitty-gritty: how capital gains are taxed under the new law:
* The top tax rate on long-term capital gains - profits on the sale of stocks, bonds, and many other investments - drops from 28 percent to 20 percent.
* "Long-term" is redefined: Assets must be held for more than 18 months, up from 12 months, as of July 29, 1997.
* Investors in the 15 percent tax bracket (income less than $41,201 for couples, $21,651 for singles) will have such gains taxed at 10 percent instead of the previous 15 percent.
* Assets sold between May 7 and July 28, and held at least one year, qualify for the new rates.
* Assets sold after July 28 and held between 12 and 18 months are taxed at the old capital-gains rates.
* Assets bought on or after Jan. 1, 2001 and held for at least five years will be taxed at a top rate of 18 percent. For investors in the 15 percent bracket, gains are taxed at a paltry 8 percent.
* Collectibles, such as art, antiques, and stamps, are still taxed at the old capital-gains rates.