YOUR TAXES : PART THREE: INVESTING, SAVING, SPENDING : Outlook is bullish for stocks and bonds : Lower rates let investors keep more of their interest, dividend income

Stocks and bonds, already enjoying a renaissance before tax reform was passed, now look even better.

That is because lower individual tax rates will let investors keep more of their profits. Tax-exempt municipal bonds also are given a boost because tax reform preserves them as one of the few remaining tax-sheltered investments available for the average investor.

“But just because taxes are less, you shouldn’t let tax strategies dictate your investment strategies,” said Larry Biehl, a financial planner in Menlo Park. Other factors, such as interest rates, inflation and the economy, will far outweigh tax rates in determining how well these investments perform, Biehl and other advisers say.

Here’s a look at how tax reform affects stocks and bonds:

Stocks

The cut in the maximum individual tax rate to 38.5% this year and 33% next year from 50% helps short-term stock investors. But the raising of the long-term capital gains tax to a maximum of 28% this year from 20% hurts investors who hold stocks for longer than six months, the period previously required to qualify for the capital gains tax.

However, at least for this year, you still will have a tax incentive to seek long-term capital gains. That is because this year the maximum capital gains rate of 28% still is lower than the maximum 38.5% rate on ordinary income.

Thus, securities bought before midyear can be sold by year-end for capital gains treatment. That could spur a year-end selloff of stocks similar to the one that hit the market at the end of last year.

Next year, however, long-term capital gains will be taxed the same as short-term profits, dividends and other so-called ordinary income. Thus, short-term traders will pay the same tax rates as long-term investors.

This change also will increase the lure of stocks paying high dividends, compared to growth stocks offering potential for high capital gains. Dividend-paying stocks tend to be more stable in price, and thus less risky, than growth stocks.

As a result, more companies are raising dividends to make their stocks more attractive. The number of dividend increases rose in December, January and February, reversing a long decline, said Arnold Kaufman, editor of the Standard & Poor’s Outlook newsletter. He expects dividends on the stocks in S&P;’s 500-stock composite index to increase between 6% and 8% this year, compared to only a 4.8% increase last year.

Mutual fund categories offering high yields include growth and income funds, which invest mainly in stocks with a track record of increasing value and paying dividends; balanced funds, which invest in bonds and preferred stocks as well as common stocks, and income funds, which invest in dividend-paying common stocks as well as corporate and government bonds.

David Sargent, chairman of the investment committee of United Mutual Fund Selector, a Boston newsletter, recommends such growth and income funds as Evergreen Total Return (800-235-0064) and Strong Total Return (800-368-3863). Among income funds, he recommends Wellesley Income (800-662-7447) and Northeast Investors Trust (800-225-6704).

Not all experts, however, say conservative, dividend-oriented stocks are the best in today’s market. Jay Schabacker, president of Schabacker Investment Management in Gaithersburg, Md., contends that the current bull market still has a lot of life. Thus, he recommends aggressive funds that emphasize stocks with high potential for capital gains, such as Fidelity OTC Portfolio (800-544-6666).

Rather pick stocks yourself? Lower corporate tax rates will help profits of such service-oriented industries as retailing, food, media, drugs and technology. Conversely, the repeal of the investment tax credit will hurt such capital-intensive industries as autos, steel, paper and chemicals.

However, stock prices to some extent already reflect these expectations, said Brian Fabbri, chief economist for Thomson McKinnon Securities. Some industrial stocks have been outperforming service-oriented issues of late, he noted.

Accordingly, experts say, you should pick stocks based on economic fundamentals, not tax considerations. “What happens with the economy, interest rates and corporate profits makes much more of a difference,” Schabacker said.

Bonds

Bonds also should be big winners under tax reform. Lower individual tax rates will let you keep more of your earnings from taxable bonds such as corporates and Treasuries. And while lower rates make the tax exemption on municipal bonds worth less, that is offset by the fact that tax reform preserves municipals as one of the few remaining tax shelters for the everyday investor.

If you’re in this year’s top tax bracket of 38.5%, a tax-exempt bond yielding 4.9% would be equivalent to a taxable bond yielding 8%. Tax-exempts issued in states with high state income taxes, such as California, can be even more valuable because their income is exempt from state tax as well. On the other hand, they tend to yield somewhat less to make up for that double advantage.

Income & Safety, a newsletter based in Fort Lauderdale, Fla., lists several California tax-free mutual funds that are exempt from both state and federal taxes. Companies offering them include Benham, Dean Witter, Dreyfus, Fidelity, Franklin, E. F. Hutton, Kemper, Merrill Lynch, National Securities & Research, Pacific Horizon, Paine Webber, Prudential-Bache, Putnam, Scudder and Shearson Lehman.

Another boost to muni investors are limitations that tax reform imposes on the volume of bonds that a municipality can issue that qualify for tax exemption. That will lower the supply of munis and increase prices of existing bonds.

But much of this price rise has already occurred since tax reform was passed, experts say. Furthermore, yields on municipals relative to taxable bonds have declined somewhat in recent months, driven down partly by increased demand for tax-exempts. Munis now pay about 85% of the yields on comparable Treasury bonds, down from nearly 100% in mid-1986 and 91% at the end of last year, Standard & Poor’s Kaufman said.

Tax reform also adds another potentially confusing twist to muni bond investing. Under the new law, interest on some types of municipal bonds, such as those financing sports stadiums, industrial development projects and other so-called “private purpose” uses, may be subject to taxation under alternative minimum tax rules. Thus, taxpayers likely to fall under the alternative minimum tax should avoid buying bonds with this drawback, said Harvey S. Gettleson, tax partner in the Woodland Hills office of Ernst & Whinney, a major accounting firm.

So although municipals are still good investments, you should proceed with caution, advisers say. If interest rates go up significantly, longer-term munis may lose much of their value.

But if interest rates go down, some existing bonds may get “called,” or redeemed before maturity, robbing the investor of part of the profit from rising bond prices, said Jay Goldinger, a broker at the Beverly Hills investment firm of Cantor, Fitzgerald.

That risk of capital loss from rising interest rates also applies to longer-term corporate and government bonds. With such risk, some advisers recommend sticking to bonds or bond mutual funds with shorter maturities, which tend to be less volatile. Money-market funds, which invest in very short-term credit instruments, are the least volatile. With less risk, however, comes less yield.

Income & Safety newsletter lists several money-market funds as “best buys.” They include Capital Preservation (800-227-8380) and Kemper Money Market Fund (800-621-1048).

For short- or intermediate-term municipal bond mutual funds, investment adviser Schabacker recommends Vanguard Municipal Bond Intermediate-Term Portfolio (800-662-7447) and Fidelity Limited Term Municipals (800-544-6666).

On the other hand, if you are willing to gamble that rates will fall further, longer-term bonds and bond funds may be a good bet. High-yield “junk bonds,” the riskiest bonds of all, can rise sharply in value if interest rates fall.

As an alternative to municipals or other conventional bonds, broker Goldinger recommends U.S. savings bonds. They are a form of tax shelter because interest on the bonds is exempt from state and local tax. Federal tax is not due until the bonds are cashed in, which could be as long as 10 years later.

Also, the investor is protected from falling interest rates because the bonds pay a minimum of 6% interest if held at least five years. If interest rates rise, the bonds could yield more. Also, savings bonds are inexpensive; one can be bought for as little as $25.

Zero-coupon bonds--which pay returns through price appreciation rather than periodic interest payments--remain good investments for individual retirement accounts or Keogh plans, advisers say. But they lose their luster as methods to lower your taxes by giving them to your children. That is because, under tax reform, children under 14 must pay taxes on the income from the zeros at the parent’s rate.

Some advisers, however, suggest staying away entirely from bonds and bond funds because much more money can be made in the stock market for very little additional risk. “Why go for a safe 8% yield in bond funds when, with a small increase in risk, you can earn 20% in stock funds?” said William E. Donoghue, publisher of Donoghue’s Moneyletter, a newsletter in Holliston, Mass.