By Karl L. Fava, CPA
as appeared in the November, 2003 edition of Staff Forum, (UAW International Staff Council), Volume 12, Issue 2
Prior to the 1990’s major tax bills were only enacted by Congress every few years. During the 90’s and our new decade almost every year we have seen a sweeping tax bill become law. Not only has the constant change and updating created confusion, it also has created many taxpayer opportunities. In the current year the Jobs and Growth Tax Relief Reconciliation Act of 2003 became law and afforded many opportunities for taxpayers and especially in the area of investments.
One of the major changes created by the legislation is the new 15% rate for qualifying dividend income and long term capital gains. Specifically, dividends paid by Corporations and Mutual Funds will be taxed at 15% if the dividend is “qualified”. The Internal Revenue Service, (IRS), definition of qualifying is somewhat involved, but in a nutshell, if the income to be paid out as a dividend was already taxed then when it is received by a shareholder it will be subject to a 15% tax. As noted, the 15% rate will also be used on long term capital gains. Long term is defined as a holding in excess of one year, therefore one year and a day. One of the greatest opportunities in this area is to take advantage of the difference between the ordinary tax rate, (which tops out at 35%), and the capital gain rate of 15%. Given that investment income from interest bearing securities such as bonds, commercial paper, bond funds, and other instruments such as this are not going to qualify for the 15% it may be better to use tax deferred accounts like IRA’s and 401(k)’s to house these investments. And, on the same hand, equity mutual funds or dividend paying corporate stock may be better suited to be housed in a taxable account since only a 15% rate would apply versus deferring the tax at ordinary rates in a tax deferred account. Under the new law a security has to be held at least sixty days to qualify for the 15% rate on dividend income. This sixty day holding period is somewhat flexible as it can be sixty days before the ex-dividend date or thirty days before and thirty days after, or sixty days after the ex-dividend date.
Given that capital gain rates on investment sales are so low, taxpayers may find this the perfect time to reallocate their portfolios. Many investors may still have capital loss carry overs from the rough markets over the last couple of years and would have the ability to offset gains with these losses, and any gains would be taxed only at the 15% if incurred post May 6, 2003. Investors holding off to sell a security with a built in gain may find this the perfect time to sell. This is especially the case if the investor does not see much more upside in holding the security but is reluctant to sell because of the tax liability involved. Re-deploying dollars freed up from a sale like this can be used for an investment that may have more upside potential than the one that was sitting for fear of paying a tax on the gain.
As noted above, investment decisions based on taxable versus non-taxable accounts need to be re-evaluated. At the same time the whole premise of deferring a large portion of one’s income into a tax deferred plan needs to be reviewed. A diligent saver should not entirely avoid utilizing tax deferred accounts given that the ultimate withdraw will be taxed at ordinary rates. Even though there is a likelihood of capital gains tax in a post tax account there still needs to be a thorough analysis and review of one’s overall portfolio and investment objectives to determine the proper allocation between pre tax and post tax savings accounts.
The above describes just a few of the changes in the tax code as established by the 2003 tax act, and specifically rules that apply to investment and portfolio decisions. As with all tax and financial related matters it is always good to review your plans and strategies with a professional in that field. The ideas and strategies promulgated may be good for some, but not others.
Karl L. Fava, CPA, MBA is president of Business Financial Consultants, Inc., (BFC). BFC located in Dearborn, Michigan is a nationwide firm providing tax and financial services to individuals and businesses across the country and offshore. In the United States BFC has clients in most major cities and aggressively seeks to maximize tax and financial strategies for them. BFC’s web site is www.bfcinc.com. Mr. Fava’s e:mail address is email@example.com. BFC’s telephone number is (313) 359-9358.