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August, 2003 Tax Tip


New Tax Law Requires Portfolio Review

To maximize the savings from the new tax cuts, there are some items that owners of mutual funds need to consider. 

Under the new law stock dividends will be taxed at a maximum rate of 15 percent from 2003 through 2008. Previously, dividends were taxed as ordinary income at rates as high as 38.6 percent.

For taxpayers in the 10 and 15 percent tax brackets,  their tax on dividends will fall to 5 percent from 2003 through 2008 and to zero in 2008.  In 2009, dividend taxes return to the rates paid on ordinary income with the highest rate being 35 percent, unless Congress later extends the tax cuts.  The new rates are retroactive to dividends paid after December 31, 2002.  IMPORTANT: As discussed below, the first thing to understand is that the lower rates don't apply to all dividends.

The new law also reduced taxes on long-term capital gains to match the dividend rates from 2003 through 2008.  In 2009, the tax rate on capital gains reverts back to 20 percent.

NOTE:  Interest payments from corporate and Treasury bonds, certificates of deposit and money market funds, which are often called dividends on 1099 forms, will still be taxed as ordinary income.

As mentioned, some stock dividends won't qualify for the reduced tax rates. Shares of most real-estate investment trusts will be excluded because REIT's as a rule don't pay corporate income tax.  One of the reasons for the dividend legislation was to prevent double taxation, which would not apply to REIT's. 

Also, the tax cuts will apply only to a portion of "balanced" funds, which include both stocks and bonds. Income from the bond portion will be taxed as ordinary income, while dividend-paying equities will get the lower rates.  The expenses of these funds will be applied to non-dividend income first, which maximizes the after-tax return of the dividend-paying portion.

It is now very important for Investors to keep in mind which dividends qualify for the lower tax rates in deciding what kind of investments to keep in tax-deferred accounts and which to have in taxable accounts.  Prior to the tax cuts, many investors had to decide whether to put investments in a tax-sheltered account or into a taxable account based on the kind of asset.   The significance of this decision has been reduced by the fact that the long-term capital gains rate was also lowered to 15 percent, which is the same as the new dividend tax rate.

It is highly recommended that investors seek the advice of their  tax or investment professional when planning their investment strategy.  I would welcome the opportunity to discuss the tax ramifications of your proposed investments with you.


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