Bernard Kent and his wife, Nina, have a New Year's ritual: Every Jan. 2, they both write checks for their maximum contribution to their individual retirement accounts (in 2003, $3,500 apiece). Neither qualifies for an IRA tax deduction. But Kent, a partner in PricewaterhouseCoopers' Detroit personal finance practice, wants to get their funds working in an IRA -- where they'll pay no tax on earnings until the money is withdrawn in retirement -- as quickly as possible.
Next year, however, the Kents may well break the habit. The tax cut passed by Congress on May 23 and signed by President Bush on May 28 sharply reduces the tax rate on investment income, whether from capital gains or stock dividends. The result: The advantage of tax-deferred savings shrinks radically, particularly on funds that will be withdrawn in 30 years or less. "At age 52, it makes a lot less sense now to defer taxes," says Kent. "Why lock up money in an IRA if it's just as cheap to pay the tax currently?" (click here for more advice from Kent on tax planning under the new rules).
Lots of investors will be rethinking old habits in the wake of the Jobs & Growth Tax Relief Reconciliation Act of 2003. While the rate cut on dividends falls far short of President George W. Bush's original plan, it's still steep enough -- from the current top rate of 38.6% down to 15% -- to rearrange the investment landscape. Dividend-paying value and income stocks are now far more attractive, but the appeal of corporate and Treasury bonds sinks, at least in taxable accounts. While the tax bill holds some hidden traps for high-income families, it offers enough new opportunities to keep accountants and financial planners busy for months (click here to see a video interview with BW's Mike McNamee on the tax plan's impact).
Whatever strategies they devise may not be firmly anchored. To keep the tax cut's cost down, Congress decided that the lower rates on dividends and capital gains would expire after 2008. But even if rates go up, the idea of taxing dividends more lightly than interest or wages is likely to persist. So you won't regret boosting your bets on dividend-paying stocks and taxable accounts.
Some of the key planning points:
INVESTMENT BREAKS. In the past, dividends were taxed at the same rate as wages, up to 38.6%. Now, most dividends will face a levy of 15%. Gains from the sale of assets held more than a year will also be taxed at 15%, down from 20%. (Taxpayers in the 10% and 15% brackets will pay only 5% on dividends and capital gains.) One caveat: The lower rates are retroactive to May 6, so dividends collected or gains realized before then are taxed at the old rates. This will make preparing 2003 tax returns thornier than ever -- calculating two rates for gains and dividends.
ASSET MIX. The sharp cut in taxes on dividends could scramble investors' preferences. Interest will still be taxed as ordinary income, with a 35% top rate, so fixed-income securities -- bonds, money-market funds, CDs -- will face a steep tax hurdle. Stocks will gain in appeal, especially those that pay good dividends.
For the past two decades, the market has been dominated by growth stocks, issued by companies that retain their profits and reward investors with capital gains, not dividends. Such shares will still have advantages: Investors can defer gains and their taxes until they sell stock -- and can time the sales to match their gains with offsetting losses. And the hottest companies will probably stay in the growth camp, because they can earn a healthy return on profits they retain. But the new tax treatment of dividends will spur investors and companies alike to push for more distribution of corporate profits as dividends.
At first blush, preferred stocks -- shares that pay a high, fixed dividend -- would also appear to get a big boost. But two-thirds of the $208 billion market in preferred shares won't qualify for the tax break on dividends, because their payout is more akin to interest than to corporate dividends. While some experts predict a flood of new preferred issues to take advantage of the tax cut, they also advise investors to steer clear for now. "Preferred-stock mutual funds will spring up to help investors sort out the accounting and get diversification," says Martin Nissenbaum, director of personal finance and taxes at Ernst & Young International.
Another investment paying dividends that doesn't fare well: real estate investment trusts. REITs, pooled funds that invest in multifamily or commercial buildings, don't pay any corporate tax. So their payouts, in most cases, won't meet the standards for the lower tax rate.
TO DEFER OR NOT? Tax-deferred accounts such as 401(k)s and IRAs postpone taxes until retirement -- but then their proceeds are taxed as ordinary income. For many taxpayers, particularly in the top brackets, it will now be cheaper to pay taxes each year on earnings at the low 15% rate. Assume you have a choice of a taxable account or a tax-deferred account, such as a nondeductible IRA or an aftertax 401(k). For an asset returning 8% in dividends and capital gains, paying 15% in taxes each year beats paying 35% tax on withdrawal, unless you're holding the account for 36 years or longer. Deferring taxes will be even more costly if top rates rise a few years out -- a good bet, considering how deficits are soaring.
Variable annuities -- hybrid accounts with the investment mix of mutual funds and the tax deferral of insurance policies -- will be big losers. Investors who have maxed out their 401(k)s and IRAs have been willing to pay stiff fees to get the tax deferral that annuities offer. Now, annuities are likely to make sense only as a vehicle for investing in high-yield bonds, which are otherwise taxed at ordinary income rates.
WHICH ACCOUNTS? Even with the lower rates on investment income, it will still pay to defer income or invest in accounts that allow you to save pretax dollars, such as deductible IRAs and 401(k)s. But the new rates put a premium on using those accounts for investments that would otherwise face stiff taxes -- like bonds. Active stock traders who take lots of short-term gains, which will still be taxed as ordinary income, should do that trading in their IRAs.
FAMILY PLANNING. Teenagers could get rich on this tax plan. If a dependent child 14 or older has taxable income of $47,450 or less, any dividends or capital gains collected will be taxed at 5%. Parents can give each teen up to $20,000 in appreciated stock each year without facing gift tax. If you trust the child not to blow the money, such transfers can cut family taxes substantially.
RATE CUTS. Almost unnoticed in the fighting over dividend-tax cuts, the most immediate impact of the legislation will be a reduction in tax rates on wage and salary income. The top rate falls from 38.6% to 35%, and rates on other brackets are cut by two percentage points -- that is, from 27%, 30%, and 35% to 25%, 28%, and 33%, respectively. Self-employed professionals and investors who pay estimated taxes can take these new rates into account in their June 16 tax payments. Salaried workers will get more aftertax pay starting July 1 and can expect a bigger refund next April unless they reduce their withholding for the second half of the year.
AMT. The disadvantage of lower tax rates: More taxpayers will be snared by the alternate minimum tax (AMT), a parallel levy that wipes out many deductions and subjects a wide range of income to a 26% rate. For 2003 and '04, Congress offers some AMT relief: For couples, the amount of income shielded from the AMT rises from $49,000 to $58,000. But in 2005, that exemption falls back to $45,000 -- and the Treasury estimates that 11.3 million taxpayers will pay AMT, vs. 2.4 million now. Most at risk: big families in high-tax states.
With a bigger bite from the AMT -- and uncertainty over whether lower rates will last past 2008 -- the new tax law is a mixed blessing for individuals. But investors who want to fine-tune their strategies will find lots of opportunities to profit. By Mike McNamee in Washington, with Susan Scherreik in New York