When you have time on your side, you can make decisions that will legally reduce your tax bill. So it's never too early to plan for your taxes. Plus, with the many tax law changes brought about by The Jobs and Growth Tax Relief Reconciliation Act of 2003, planning for your 2003 taxes is more important than ever. Here are some ways to take advantage of many of the benefits provided in the new law.
Lower capital gains tax rate
Long-term capital gains realized after May 5, 2003 will be taxed at a new maximum 15% rate (down from the old 20% maximum rate). This lower rate makes holding stocks and other capital assets for the long term (more than one year) more attractive than ever before.
But before you rebalance your portfolio, remember also that the lower capital gains tax rate cuts both ways. If you sell some of your loser stocks (either short or long term) and use those losses to offset long-term capital gains, those losses will give you only a 15% tax benefit. Also, remember that you're limited to a $3,000 capital loss in any one year, regardless of your total losses. So it's really important that you take a hard look at your portfolio in order to make sure that you take the maximum advantage of the lower capital gain rates.
You'll generally want to keep your gains long term, your losses short term, and think twice before automatically offsetting long-term gains with losses of any kind. Finally, if you're selling any of your investments at a loss, don't forget to avoid the wash-sale pitfall, i.e., the loss cannot be immediately claimed for tax purposes if you sell stock for a loss and buy it back within the 30-day period before or after the loss-sale date.
Lower dividend tax rate
Dividend-paying stocks have become more popular since those dividends will now be taxed at the 15% rate, rather than counted as ordinary income. This is a very big deal, especially for somebody in the highest federal bracket (35%). Even for the majority of taxpayers who reside in the 25% bracket, a reduction of taxes paid on dividends received is still a pretty nice tax break.
So, as you're looking to adjust the focus of your portfolio, you might want to consider allocating more of your investment dollars into dividend-paying stocks and out of investments paying interest (such as taxable bonds) or those not qualifying for the lower tax on dividends (such as many mutual funds and real estate investment trusts, among others).
Transfers to kids
A terrific way to reduce (or even avoid) the tax on appreciated stock is to give it to your kids. The child can make sure to hold the stock for more than one year, and sell it after he or she turns 14 (in order to avoid the kiddie tax rules). If the kid's income is low enough, the gain will be taxed at 5% (as opposed to your 15%). Even after the kid sells the stock, if you think that there is upside potential remaining, you can buy it right back. You don't have to worry about the wash sale rules (they don't apply to gains), and you'll then own a stock that you love with a higher cost basis since your child took advantage of the gain at much lower tax rates.
Taxable vs. tax-deferred accounts
The bloom is off the rose of tax-deferred accounts. Remember that dividends and long-term gains realized in a tax-deferred account receive no special tax treatment. When those earnings are withdrawn from the tax-deferred account, they will be taxed to you at your ordinary tax rate, however high that might be at the time. So you're trading tax-deferral for a potentially (almost certainly) higher tax rate when that income is distributed out of the account. With that in mind, you might want to make sure that your tax-deferred account holds investments that throw off interest (rather than dividends), or other non-qualifying dividends.
You might also want to keep your gains short term in your tax-deferred account. At the same time, use your taxable account to hold your investments that throw off qualifying dividends and long-term capital gains. Over time, the reduced tax rates on those dividends and gains will allow the after-tax return in your taxable account to more closely match the after-tax return in your tax-deferred account. (If you'd like to learn more about tax-deferred accounts, visit our IRA Center.)
If you're a business owner, don't forget about the new depreciation rules on assets purchased this year. You'll receive a 50% bonus depreciation (up from 30%) for assets purchased after May 5, 2003. Additionally, the Section 179 expensing limitation has also been increased from $25,000 to $100,000. Both of these benefits are set to expire in just a few years, so it might make sense to plan for any major purchases in the very near future.
Consider dividends over compensation
If you're an owner of a "C" corporation, consider paying dividends to yourself as opposed to wage compensation. Wages are taxed at your highest bracket, while dividends are taxed at a lower 15% rate. Also, by paying dividends you'll avoid payroll taxes on any wage compensation. You will pay corporation taxes on the corporation earnings, but you might still be better off after all things are considered.
These are just a few of the moves to consider when you take a look at your taxes and investments this summer. Make the most of the new law changes and reduced tax rates. There's no reason to pay Uncle Sam more than your fair share.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.