Monday, October 11, 1999


Answer to tax queries: It depends

The Cincinnati Enquirer

        Remember the old guarantee about death and taxes? A few Enquirer readers did after last week's “Your Money” column, and contacted us about it — at least about the taxes part.

        That column focused on paying off (or rather, not paying off) mortgage debt and wasn't really about income taxes. But this column will be.

        First, a little background: We told you last week that you could make more money in stocks (with historical average returns about 10 percent to 12 percent) than you would save by paying off your mortgage (assuming about 7.7 percent interest).

        If you have an extra $10,000 laying around, you could invest in stocks and earn $1,000 to $1,200, or you could pay down the mortgage and save $770 in interest — $493 after the mortgage interest income tax deduction if you're in the 36 percent tax bracket.

        “Don't you have to pay capital gains on that money?” one reader e-mailed about the thousand-dollar-plus gain.

        The answer to that, and so many other financial and tax questions, is simple: It all depends. It depends on how the money is invested and how the gains are taken.

        “It all comes back to how you are holding the assets,” said Rob Bult, a financial adviser and principal in downtown's Fitzgerald Lame Torbeck Group/J.C. Bradford & Co. “If you're holding onto that investment long term, it can continue to grow tax-deferred.”

        Tax-deferred doesn't mean tax-free. But it does make the eventual bite easier and still makes holding onto mortgage debt worth it in the long run.

        Mr. Bult said, outside of retirement accounts, the best way to ensure that an equity investment can grow tax-deferred is simply to not sell it.

        Selling stock after more than 12 months incurs capital gains tax, currently 20 percent on the increase in the investment's value. Sell inside of 12 months, and the increase will be taxed at normal tax rates (36 percent here in our hypothetical example).

        Let's assume you hold on to it long term: If your initial $10,000 grows to $16,105 after five years of 10 percent compounded returns and you sell, you would pay $1,221 in capital gains (20 percent of the $6,105 gain).

        Other income taxes might be applicable, depending on the dividends over those five years. Still, you're likely to come out ahead more than $4,500 — compared with saving around $2,000 on your mortgage interest — at the end of those five years.

        Mr. Bult said anyone with a spare $10,000 laying around also should investigate an Individual Retirement Account. Tax laws don't allow you to pour all $10,000 into an IRA at once, with funding limits being determined by income tax filing status and income levels. (Roth IRAs are another option — but that's a subject for another column.)

        IRAs are still not tax-free, however, with disbursements from the IRA after age 591/2 still taxed as if they were ordinary income, Mr. Bult said.

        About the only tax-free way to invest that money would be through municipal bonds, whose interest payments are not considered taxable income. The problem with those investments is that the interest paid on the bonds is typically going to be lower than your mortgage — and much, much lower than average historical stock market returns.

        So, if you expect to get any kind of value from your spare $10,000, be ready to pay taxes. Planned well and done right, however, taxes can be minimized, and you'll still usually fare better than paying off the mortgage. But because every situation is different, there's no easy answer on how much tax you'll pay.

        “It all depends,” Mr. Bult said. “There are always those "if' statements in there.”

        Now death — no "ifs' there ...

        Amy Higgins writes about personal finance for The Enquirer. You can reach her at 768-8373,, or Your Money, The Cincinnati Enquirer, 312 Elm St., Cincinnati 45202.


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