Significant reduction in taxes paid on dividends and capital gains were signed into law as part of the federal tax-cut package. These offer strong incentives to save and invest money. Since the changes may affect your investment strategy, it’s important that you understand the tax cuts. Also, meet with your financial advisor to see how you may benefit. The information here provides some basic insights:

Lower Tax Rates on Dividends, Capital Gains
Starting this year, and continuing through 2008, the top rate on dividends drops dramatically, from 38.6 percent to 15 percent. Meanwhile, the top rate on most capital gains drops from 20 percent to 15 percent. If you are in the 10 percent or 15 percent income-tax brackets, the tax rate on capital gains or dividends drops to 5 percent until 2007, and to zero in 2008.

The reduction in capital-gains taxes applies only to gains occurring on or after May 6, 2003. However, the dividends-tax reductions are retroactive for this tax year. Dividends received from Jan. 1, forward, may be eligible for tax savings.

To be eligible for the capital-gains tax cuts, however, you must have held on to the investment for more than one year. If you haven’t, the gains are taxed at the same rate as ordinary income. Presently, dividends and interest are both taxed as ordinary income. Note that the top marginal rate falls from 38.6 percent to 35 percent this year under the legislation.

Which Dividends are Eligible?
Shareholders will get the tax break on corporate stock dividends of most U.S. and foreign companies so long as the stock trades in the United States. Note that earnings you may have thought were dividends, may in fact be interest or another form of payment that’s not eligible for the lower tax rates. Here are some examples:

  • Interest: Interest from corporate and Treasury bonds, certificates of deposit, money-market funds and such will continue to be taxed as ordinary income.
  • Preferred stocks: If the preferred stock is an equity, the dividend qualifies for the tax cut. However, if the preferred stock is considered a debt instrument for tax purposes – which many are – the dividend is really interest and will be taxed as ordinary income. To avoid confusion, talk to your financial advisor.
  • Real-estate investment trusts: REITs must pass on at least 90 percent of their profits to shareholders. Thus the profits are left mostly untaxed at the corporate level. As a result, most REIT dividends will be taxed as ordinary income. However, when REIT shareholders sell their shares, any profit will be taxed at the new, lower capital-gains rate – but only if the shares are held for more than a year.
  • Municipal bonds: Interest from municipal bonds will remain exempt from federal taxes, as well as from state taxes if issued by your home state. If you sell the bond at a profit before maturity and have held it for more than a year, it will qualify for the lower capital-gains rate.

How Will I Benefit?
The potential tax savings are a significant reason for you to review your portfolio for long-term goals, risk tolerance and tax liability. Consider asking these questions:

  • Given the lower tax rate, should I now realize gains that have accumulated during the past few years, and reinvest them elsewhere?
  • Should I change my portfolio’s balance between stocks paying steady dividends and those that have made substantial gains? Should I move away from fixed-income investments and toward stocks paying steady dividends in order to benefit from the new tax rate?
  • Given that the savings may stop by year’s end 2008, should I try to realize any gains by then? Or, should I move away from dividend-paying stocks to securities that are expected to rise in value?
  • Is my account affected by stock lending? If so, how would receiving the tax cut affect what I could claim as dividends? Could I switch into an account that is not affected by stock lending?
  • What about a tax-sheltered account, such as an Individual Retirement Account? Should I move bonds and other interest-bearing investments between taxable and tax-deferred/nontaxable accounts to minimize my tax bill?

With retroactive, temporary, phased-in and phased-out provisions, this new law makes tax planning more complicated. Don’t hesitate to seek advice.

This column is produced by Financial Planning Associates, and is provided by R. Hutton Cobb, a Wachovia Securities financial advisor in Greenville, N.C.