Tax Cut Pays Big Dividends

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Tax Cut Pays Big Dividends
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
May 23, 2003

Updated on May 11, 2006 to include new 2006 tax law changes.

The new tax package is good news for investors, and families and small businesses should also benefit. Here are some practical steps you can take to maximize your after-tax wealth in light of the new law.

Let's start with the big news.

Lower taxes on dividends and capital gains

The long-term capital gains rate is now 15 percent for sales on or after May 6, 2003. The old rate was 20 percent.
Dividends are now taxed at the new long-term capital gain rates instead of at your ordinary income tax rate, retroactive to Jan. 1, 2003.
For people in or below the 15 percent ordinary income tax bracket, the new long-term capital gains rate is 5 percent and goes to zero after 2007.

Dates to remember

	Effective	Expires*
Long-term capital gains rate of 15% or 5%	Sales on or after May 6, 2003	Dec. 31, 2010 (5% rate becomes 0% after 2007)
Dividends taxed at long-term capital gains rate	Jan. 1, 2003	Dec. 31, 2010
Lower income tax rates	Jan. 1, 2003	Dec. 31, 2010 (2003 changes expire in 2006 when same lower rates were previously scheduled to take effect)

*Unless extended or made permanent by Congress.

Keep in mind this provision is set to expire after 2010.

What do the new dividend and capital gains rules mean for investors?

The new long-term capital gains rate bolsters the case for buying and holding stocks, tax-managed mutual funds and index funds in taxable accounts instead of tax-deferred accounts over the long term (more below).
Dividend-paying stocks may now be viable candidates for taxable accounts vs. tax-deferred accounts. The reason? Withdrawals from tax-deferred accounts (other than Roth IRAs) are taxed at your ordinary income tax rate, which may be higher than the new capital gains rate for dividends. Crunch the numbers to make sure it makes sense for you.
Don’t switch from taxable bonds to dividend-paying stocks simply for tax reasons. Investing in stocks carries risk. Make sure the investments you choose suit your goals, asset allocation, income needs and ability to sustain losses.
Consider gifting long-term assets to family members age 18 or older. They’ll typically pay only 5 percent in long-term capital gains tax (zero percent after 2007) vs. the 15 percent rate you would likely pay.

Lower income tax brackets
Lower income tax rates were scheduled to phase in over the next few years. But the new law delivers them early—the rate cuts are now retroactive to Jan. 1, 2003 (see chart).

Old law—phase-in of marginal income tax rate reductions

Pre-2001	15%, 28%, 31%, 36%, 39.6%
2001	15%, 27.5%, 30.5%, 35.5%, 39.1%
2002-2003	10%, 15%, 27%, 30%, 35%, 38.6%
2004-2005	10%, 15%, 26%, 29%, 34%, 37.6%
2006-2010	10%, 15%, 25%, 28%, 33%, 35%
2011 and beyond	Back to pre-2001 law if no action by Congress

New law—2003 rate schedule

Rate	Single	Married filing jointly
10%	$7,000 or less	$14,000 or less
15%	Over $7,000 but not over $28,400	Over $14,000 but not over $56,800
25%	Over $28,400 but not over $68,800	Over $56,800 but not over $114,650
28%	Over $68,800 but not over $143,500	Over $114,650 but not over $174,700
33%	Over $143,500 but not over $311,950	Over $174,700 but not over $311,950
35%	Over $311,950	Over $311,950

Factor in the new rates beginning with this year.

Re-run your 2003 tax projections to see if the new withholding rates make sense for you. If you make quarterly estimated tax payments, revisit your payment schedule—you may be due a bigger refund.
Reevaluate your strategy if you were planning to defer income into next year based on the now-implemented rate reductions.
Does it still make sense to hold municipal bonds instead of taxable bonds in your taxable accounts? It might, especially if you have in-state bonds and your state raised (or plans to raise) its marginal income tax rate.
As mentioned above, taxpayers in higher brackets should still benefit from holding tax-efficient stocks and mutual funds in taxable accounts if they plan to hold them for the long term. That now goes for dividend-paying stocks as well. Likewise, it still makes sense to put less tax-efficient investments—taxable bonds, stocks you hold for one year or less, and actively managed mutual funds—in tax-deferred accounts.

The significant factor here is that the difference between the long-term capital gains rate and income tax rates hasn't changed significantly. For example:

Pre-2001, the highest ordinary federal rate was 39.6 percent and the long-term capital gains rate was 20 percent—a difference of 19.6 percent.
Now, the highest ordinary federal rate is 35 percent and the long-term capital gains rate is 15 percent—a difference of 20 percent, virtually the same as before.

Remember, the old “sunset” provision from the 2001 tax law is still out there. That means in 2011 we go back to pre-2001 income tax rates unless Congress passes an extension or makes the changes permanent.

Other important changes:

Alternative Minimum Tax relief. The exemption is a bit higher to help prevent more taxpayers from inadvertently entering the AMT ranks, at least for 2003-2004.
Family-friendly changes. The standard deduction is increased and the 15 percent bracket expanded for married taxpayers filing jointly for 2003-2004, providing some “marriage penalty” relief. Additionally, the child tax credit is increased to $1,000 per child for the same period.
Small business relief. Section 179 of the Internal Revenue Code may not mean much to you as an individual, but if you own a small business it could be a big deal. This section of the Code lets small business owners expense a portion of the purchase cost for capital equipment put into service during the year, instead of having to depreciate it more slowly over a period of years. The new section 179 limit has been raised to $100,000 through 2005 in the hope of providing a shot in the arm for the economy. Bonus depreciation is also increased from 30 percent to 50 percent through 2004.
State aid. The tax package includes $20 billion in aid to state and local governments in 2003 and 2004. That may keep local income taxes from rising more than they otherwise might.

To learn more about these changes, look for official updates on the IRS Web site. Be sure to consult your professional advisors before you take action—and don’t forget to think about investing some of your refund.

The information and content provided herein is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, or legal, tax, or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professionals to help answer questions about specific situations or needs prior to taking any action based on this information.

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