Though President Bush at one point referred to the Jobs and Growth Tax Relief Reconciliation Act of 2003 as “an itty bitty tax cut,” the new law contains more than $330 billion in cuts. With proper planning and a little luck, both individuals and small businesses can realize meaningful tax savings.
For many of the changes affecting individuals, a person either qualifies or does not. These include the child credit and the elimination of the marriage penalty. Yet planning opportunities exist, thanks to a reduction in the tax rates on long-term capital gains and certain dividends. The law also accelerates reductions in individual tax rates previously scheduled to occur in 2006, with the highest marginal tax rate now 35% through 2010.
Opportunities For Individuals
Capital gains on most property sold after May 5, 2003, and held for more than one year are taxed at 15% (down from 20%). Also, beginning Jan. 1, 2003, most taxpayers will pay a 15% tax (down from a high of 38.6%) on qualifying dividends paid through 2008 by domestic corporations and foreign corporations whose stock or ADR (American Depositary Receipt) is traded on an established U.S. market or otherwise qualifies under a U.S. tax treaty. Complicated rules govern what actually qualifies as a dividend, but generally, dividends from common or preferred stock of most publicly traded companies are eligible. In the mutual fund world, dividends that are really interest payments, such as from a bond fund, do not qualify. Also, most shareholder distributions from Real Estate Investment Trusts (REITs), publicly traded real estate companies that invest in commercial properties, are unlikely to qualify because such distributions are generally not subject to corporate tax in the REIT. Absent future legislation, dividends paid after 2008 will be taxed at regular income tax rates, and the long-term capital gains rate reverts to a maximum of 20%.
Of course, now that there is a potential 20% spread between the short-term (ordinary) and long-term capital gains rates, being aware of the one-year holding period becomes even more important. This rate spread has led many investment professionals to recommend holding fixed-income investments, which generate interest income subject to higher ordinary income tax rates, in tax-deferred accounts such as IRAs and 401(k)s. Stocks that generate dividend income and long-term gain accordingly would be held in taxable accounts, even if this requires adjusting investment strategies and the asset allocation between these accounts. While this strategy may be advantageous in the short term, determining whether it works over the long term may require careful analysis. Generally, if you hold equity investments in a tax-deferred retirement account for a long period, say a decade or more, you might be better off even though you give up the advantage of the lower tax rates in your taxable account in the short term. After all, it would be foolhardy to allow the tax tail to wag the investment dog.
Individuals with large positions in low-basis stock now have a chance to diversify their portfolios at a significantly lower tax cost. For example, assume a business owner sold her company many years ago for stock in the purchasing company in which her basis was $100,000. Now the stock is worth $2 million. Under the new rules, if she were to sell her stock, her long-term capital gains tax, assuming no other gains or losses, would now be $285,000, which is $95,000 less than last year.
Even though a lower ordinary income tax rate will make taxable bonds more competitive with tax-free municipal bonds, investors still should consider the after-tax yield of municipal bonds. For example, Vanguard’s Admiral Treasury Money Market Fund recently had a yield of 0.86%, while Vanguard’s national municipal money market fund, the Tax-Exempt Money Market Fund, had a yield of 0.71%. However, assuming a marginal income tax rate of 35%, the after-tax yield of the Treasury Money Market fund was only 0.56%. (These figures disregard state taxes.)
Unfortunately, the decrease in ordinary income tax rates will expose more taxpayers to the bizarre world of Alternative Minimum Tax (AMT), which calculates an additional tax liability using an alternate set of rules. Generally, things that reduce your regular federal income tax, such as lower tax rates or higher deductions, may trigger or increase AMT liability. This year’s reduction in federal tax rates will therefore increase some taxpayers’ AMT even though Congress did grant a slight increase in the amount that can be exempted from the alternative tax.
To make matters worse, many states have increased their own income and property taxes. Because these items are deductible for taxpayers who itemize on their federal returns, residents of states that have raised taxes will also find themselves subject to a greater AMT burden.
Careful planning can mitigate your AMT whammy, but such planning is often contrary to traditional tax planning. For instance, you should consider postponing state income tax payments currently due until next year. The potential underpayment penalty and interest levied by the state may actually be smaller than the additional AMT cost triggered by making the payment.
Business Benefits
The new law benefits businesses by increasing depreciation deductions and outright write-offs for certain new assets. Generally, a certain amount of the cost of tangible personal property used in a trade or business may be immediately deducted in the year of purchase, with the remainder depreciated over a longer time period. The new law increases the potential maximum amount of this initial write-off through 2005 from $25,000 to $100,000 for small businesses with equipment purchases of up to $400,000. Computer software now is eligible for this expense provision.
The new law also increases the “bonus” depreciation allowance (introduced in an earlier tax cut law) from 30% to 50% for certain property purchased by all businesses from May 6, 2003, through 2005. Combined, these changes provide both small and large businesses with substantial tax breaks to acquire new assets and replace obsolete equipment before the provisions expire at the end of 2005, absent further legislation. Not too bad for “an itty bitty tax cut.”
