By Raymond D. Mignone
The implications of the new tax reductions are very beneficial to all of us here in Queens, especially retirees who derive a large portion of their income from dividends and capital gains. Unfortunately, while the federal government is reducing income taxes New York has increased them slightly.
I would like to discuss some of the highlights of the changes. Investors with investment income in the form of long-term capital gains and dividend income will receive significant benefits from the 2003 Tax Act.
Capital gains tax rates are reduced for sales made after May 5, 2003. The maximum long-term capital gains tax rate is 15 percent (previously 20 percent) and for many retirees who are in the 10 percent and 15 percent tax brackets the new rate is only 5 percent. (previously 10 percent). Keep in mind New York doesn’t have a lower tax rate for long-term capital gains.
The new law makes now a good time to think about selling any real estate that you may have a large capital gain on. Also, if your portfolio is way out of balance because you have some stocks that you owned for a long time with large capital gains now would be a good time to think about selling off some of these stocks and paying the lower tax. I doubt that the capital gains rates will ever get lower than this and who knows how long this will really last.
Dividends received from domestic or qualified foreign corporations will be taxed at the same rates as long-term capital gains. Certain types of dividends are excluded, such as dividends from REITS. The change in tax rates for dividend income may change your preference for dividend income versus interest income. Of course if dividends or interest are earned inside a retirement plan then there is no benefit since withdrawals are still taxed at the regular tax rates.
Two of the most significant changes in the 2003 Tax Act are the acceleration of reductions in ordinary income tax rates and the increase in the child credit. The 10 percent tax bracket has been expanded and reductions in tax brackets above 15 percent have been accelerated and roughly lowered by 2 percent.
Some relief is also provided from the marriage penalty. Many benefit and deduction amounts for married couples are less than twice the amount available for single individuals. Those provisions can cause married couples to pay more in income taxes than if they were single. Typically, couples with income more evenly split than 70 percent for one spouse and 30 percent for another spouse will pay more income taxes than if they were single.
The standard deduction for married couples filing jointly is now double the amount for single taxpayers. The 15 percent tax bracket for married couples filing jointly is now twice the amount for single taxpayers.
There are also important advantages of mutual funds in the new tax changes. For example, the new law stipulates that a mutual fund that earns 95 percent of its income from sources that are covered by the new lower dividend-tax rate can actually treat 100 percent of its income as tax-advantaged. So, if a fund gets 95 percent of its income from stock dividends, but the remaining 5 percent comes from bonds, Treasury bills, or REITs, the fund can roll up all its income in the form of a distribution that will be taxed at the lower rate. If you owned a similar mix directly or through other vehicles such as separate accounts, you wouldn’t get that advantage.
In addition, funds take their expense fees out of their income stream, and they are allowed to designate income taxed at higher rates to pay for the expense ratio. So if a fund generates only 90 percent of its income from tax-advantaged equity dividends, but its expense ratio sucked up 10 percent of its income stream, the fund could still pay out all of its income in a lower-tax-rate payment because the income that would have been taxed at the higher rate went into paying expenses.
The new tax law can have major implications on how you allocate your investments between your taxable accounts and your retirement accounts. You should review your overall asset allocation and your tax return with your financial advisor to see if there are ways that you can improve your overall after tax return.
Raymond D. Mignone is a fee-only Certified Financial Planner & President of Ray Mignone & Co. Inc. Specializing in retirement planning and investment management; he can be reached in Little Neck at 718-229-2514 or go to www.raymignone.com.
