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How To Exploit The New Tax Law

YOU'VE PROBABLY HEARD by now that President Bush's latest tax cut likely means more money in your pocket. (To see just how much, check out our calculator.) But when it comes to investing, chances are you're a little confused about how to take fullest advantage of the new rules.

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.

· Sometimes what a mutual fund labels as a "dividend" distribution may include more than just dividends. It could, for example, include a fund's short-term capital gains, interest income and other types of ordinary income — all of which are still taxed at your regular rate. The good news is that mutual-fund dividends paid out of qualified dividends from the fund's stock investments and long-term capital gains are eligible for the new 15%/5% rates. (This means mutual-fund annual statements will now have to identify the amount of dividend payments eligible for the reduced rates as well as ordinary income amounts that are taxed at regular rates.)

· Most REIT dividends will not be eligible for the 15%/5% rates. Why? Because the main sources of REIT payouts are usually not qualified dividends on stock owned by the REIT or long-term capital gains from investments sold by the REIT. Instead, the source is usually cash-flow generated by the REIT's real-estate properties. Therefore, most REIT dividends will be taxed as ordinary income. (One REIT industry source estimates that only 25% of REIT dividends paid in recent years would have qualified for the reduced rates.)

· If you invest in a savings account through a credit union, the interest earned is labeled as a "dividend." Unfortunately, these aren't actually dividends — they're just regular ol' interest payments. As such, they're considered ordinary income and are taxed at your regular rate, which can be as high as 35%. The same is true for dividends paid on some preferred stock issues that are actually publicly traded "wrappers" around underlying bundles of corporate bonds.

· Finally, the reduced rates don't apply to dividends earned inside your tax-deferred retirement accounts (traditional IRA, 401(k) account, SEP account, Keogh account and so on). Dividends accumulated in these accounts are taxed at your regular rate when withdrawn as cash distributions. (Dividends 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 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
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).

· 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.

· 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.)

· 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.)

· You'll be taxed at your regular rate on short-term capital gains from investments held in taxable accounts for one year or less, just as you were under prior law. So if you hold appreciated stock in a taxable account for exactly one year, you could lose up to 35% of your profit to the IRS. If, however, you hold on for just one more day, your tax rate will drop to no more than 15%. For tax purposes, your holding period begins the day after you acquire securities. Your holding period includes the day you sell. For example, say you buy stock on Sept. 1 of this year. Your holding period begins on Sept. 2. So Sept. 3 of next year is the earliest possible date you can sell while still remaining eligible for the new and improved long-term capital-gains rates.

· In tax terminology, the amount of long-term real-estate gain attributable to depreciation deductions claimed against the property is called unrecaptured Section 1250 gain. It's still taxed at a maximum rate of 25%, as under prior law. The good news: Any long-term gain over and above the amount of unrecaptured Section 1250 gain on your property is now eligible for the new 15%/5% rates. The same is true for gains included in installment payments that you receive on or after May 6, 2003, from an earlier deferred payment sale transaction.

· The 28% maximum rate on long-term gains from collectibles and certain small-business stock remains in force, as under prior law.

Strategies: Tax-Smart Moves for Your Capital-Gain Assets
· For appreciated equities held in your taxable accounts, it now pays to try even harder than before to satisfy the more-than-one-year holding-period rule in order to qualify for the sweet 15%/5% rates on long-term capital gains. The higher your regular rate, the more this advice rings true. That said, it obviously doesn't make any sense at all to expose an accrued profit to great downside risk solely to qualify for a lower tax rate. Put another way, it's always better to earn a short-term profit and pay the resulting higher tax bill than to lose your profit by hanging on too long.

· Hold mutual funds that engage in rapid-fire churning in your tax-advantaged retirement accounts, where hyperactive trading activity doesn't cause any tax disadvantage.

· Likewise, confine your rapid-fire stock trading to your tax-advantaged retirement accounts. Inside these accounts, there's no tax disadvantage to swinging for the fences with profitable short-term trades.

 Winners and Losers
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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