How To Exploit The New Tax Law
First, let's review the changes. Now, all of your ordinary income (from wages, interest, retirement-account withdrawals, alimony and so forth) will be taxed at lower rates, with the highest federal rate now being 35%, vs. 38.6% under old law. Better yet, the highest rate on qualified dividends and long-term capital gains is now only 15%, and only 5% for the many folks who occupy the 10% and 15% tax brackets (see table below).
So does this mean you need to rethink your investment strategies? You betcha. You also need to know which rules haven't changed under the new tax code. Here's our guide to the new era of tax-friendly investing.
Not All Dividends Are Created Equal
The new, greatly reduced tax rates on dividends apply only to qualified dividends from corporations. To be eligible for the reduced rates on qualified dividends, you must hold the stock on which the dividends are paid for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the day after the last day on which shareholders of record are entitled to receive an upcoming dividend payment). So if you own shares for only a short time around the ex-dividend date, the dividend will constitute ordinary income and be taxed at your regular rate.
Simple enough, right? Well maybe not, because lots of payments that are commonly called "dividends" aren't qualified dividends under the tax law.
Strategies: Tax-Smart Moves for Income-Producing Investments
The new law makes it disadvantageous to hold ordinary income-producing investments in taxable accounts, compared with stocks that generate qualified dividends and long-term capital gains. So my advice is to put fixed-income assets that generate ordinary income (like Treasurys, corporate bonds and CDs) into your tax-deferred retirement accounts. This avoids any tax hurt.
The new law also makes it disadvantageous to hold REIT shares in your taxable accounts, compared with garden-variety corporate shares that generate qualified dividends and long-term capital gains. As you know, REIT shares deliver current income in the form of high-yielding dividend payouts, plus the potential for capital gains, plus the advantage of diversification. Inside a retirement account, these are all fine attributes. Inside a taxable account, however, REIT shares don't receive the same favorable tax treatment as garden-variety corporate shares. So all other things being equal, retirement accounts are now generally the best place to keep your REIT stocks.
Finally, hold equity index mutual funds and tax-managed funds in your taxable accounts. These funds are much less likely to generate ordinary income-dividend payouts that will be taxed at your higher regular rate.
| Surprise! Lowest Tax Brackets Are Wider Than You Think |
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Qualified dividends and long-term capital gains earned in taxable accounts are taxed at only 5% for those in the 10% and 15% rate brackets. And thanks to other changes made by the new law, these bottom two brackets now include many more people than you might think. Remember, your tax bracket is determined by your taxable income, which equals gross income reduced by allowable personal and dependency exemptions and the standard deduction (if you don't itemize) or the total of your itemized deductions (if you do).
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Say you're a married joint filer with two dependent kids. Guess what? Assuming you claim the standard deduction, your gross income for 2003 can be as high as $78,500, and you'll still be within the 15% bracket. So if your gross income, including dividends and long-term gains, is below that figure, you'll pay only 5% on the dividends and gains.
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Say you're a single parent with two dependent kids. You claim the standard deduction and use head-of-household filing status. Your 2003 gross income can be as much as $54,200, and you'll still be in the 15% bracket. So you, too, will qualify for the 5% rate on dividends and long-term gains. (If you're divorced, gross income doesn't include any child-support payments received from your ex-spouse.)
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Say you're single with no dependents and you claim the standard deduction. Your gross income can be as much as $36,200, and you'll still be in the 15% bracket.
You get the idea. You actually don't have to be anything close to poverty stricken to be eligible for the new 5% rate on dividends and long-term gains. That said, you should still take full advantage of all opportunities to make deductible contributions to your tax-deferred retirement account. Then you can invest the resulting tax savings, along with any other surplus cash, in a taxable account with the idea of benefiting from that incredibly sweet 5% rate. |
Some Gains Don't Qualify for Reduced Rates
The new capital-gains rate cuts weren't extended to all types of investment gains. Here's what's not eligible:
First and foremost, the reduced rates on long-term capital gains have no impact on investments held inside your tax-deferred retirement accounts. Gains accumulated in these accounts will still be taxed at your regular rate when withdrawn as cash distributions. (Gains accumulated in your Roth IRA are still federal-income-tax-free as long as you meet the requirements for tax-free withdrawals.)
Strategies: Tax-Smart Moves for Your Capital-Gain Assets
| Winners and Losers |
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Tax-Smart Winners for Retirement Accounts ·
Stocks that you expect to trade rapidly. ·
Quick-churning equity mutual funds. ·
REIT shares. ·
High-yield junk-bond mutual funds. ·
High-quality fixed-income assets.
Tax-Smart Winners for Taxable Accounts ·
Growth stocks that you expect to hold for more than a year. ·
Stocks that pay healthy dividends that you expect to hold for more than a year. ·
Equity-index and tax-managed mutual funds. ·
Tax-free municipal bonds and municipal-bond funds. However, watch out for state-income taxes. Try to avoid private activity bonds that can throw you into the alternative minimum tax trap. ·
Fixed-income assets and REIT shares — but only if your tax-advantaged retirement-account balances are fully dedicated to rapid-fire equity trading and ownership of quick-churning equity mutual funds.
Losers by All Accounts · Variable annuities. These are mutual-fund investments wrapped inside a life-insurance policy. Your earnings are tax-deferred, but they're treated as ordinary income when withdrawn. So you'll pay your regular tax rate at that time even if most or all of your earnings were from dividends and capital gains that would otherwise qualify for the new 15%/5% rates. This factor, plus the high fees charged by insurance companies on variable annuities, makes these products very problematic. It can take many many (too many) years for the tax-deferral advantage to overcome the inherent disadvantages. If you ever catch up at all, that is.
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