New Tax Laws Offer New Ways To Save

Evaluate your income, find out your tax bracket and seek ways to keep it low

HUMBERTO CRUZ Tribune Media Services

It was important before but much more so now: figuring out how much of your income, if any, should come from stock dividends and long-term capital gains, and in what year.

To get the most savings from the new tax law, you also need to know what your tax bracket is and what steps you can take to lower it.

"Knowing your tax bracket is probably the first step in tax and financial planning this year," said Benjamin Tobias of Tobias Financial Advisors in Florida, a certified financial planner for 15 years and certified public accountant for 22.

To see why, let's review some of the main investment-related provisions of the tax bill approved by Congress last month.

I'll begin with long-term capital gains, which are gains from the sale of assets such as stocks, bonds and mutual funds held more than a year.

Beginning with sales made this past May 6 and through the end of 2008, long-term gains are taxed at a rate of 15% for taxpayers in the four top tax brackets, which are 25%, 28%, 33% and 35% now.

Before, long-term gains were taxed at a 20% rate for taxpayers in the top brackets, which used to be 27%, 30%, 35% and 38.6%.

For taxpayers in the other two brackets, which remain at 10% and 15%, long-term gains are now taxed at 5% though 2007, and are tax-free in 2008. Before, taxpayers in the bottom two brackets paid a 10% tax on long-term gains.

Also under the new law, dividends from stocks and stock mutual funds paid on or after Jan. 1, 2003, are taxed at 15% through 2008 for taxpayers in the top four brackets. For taxpayers in the 10% and 15% brackets, dividends are taxed at 5% though 2007 and are tax-free in 2008.

Before the new law, dividends were taxed at the taxpayer's tax bracket, which meant as high as 38.6%.

The offshoot is that investment earnings from dividends and long-term capital gains have become more attractive from a tax standpoint. By comparison, interest income, short-term capital gains on the sale of assets held for a year or less, and most distributions from real estate investment trusts are still taxed at the taxpayer's bracket, now as high as 35%.

Thus the new law favors longer-term stock investing and investment on dividend-paying stocks, at least through Dec. 31, 2008, when the recently enacted cuts "sunset" or end unless Congress votes to extend them.

The law also increases the appeal of low-expense dividend-paying stock mutual funds because expenses are subtracted before a fund pays out its dividends. It diminishes the attractiveness of variable annuities, in which gains grow tax-deferred but are taxed at the taxpayers' tax bracket on withdrawal. And it provides another argument for holding "tax-inefficient" investments such as high-yield bonds and real estate investment trusts in tax-deferred accounts, such as traditional IRAs.

While these issues have been covered extensively in the news accounts, scant attention has been paid to how more people can take advantage of the new rates by staying in the lowest two brackets.

Although these brackets remain at 10% and 15%, more people now qualify for them. Retroactive to Jan. 1, the top of the 10% bracket in 2003 went up from $6,000 to $7,000 of taxable income for single filers, and from $12,000 to $14,000 for married filing jointly. The top of the 15% bracket remains at $28,400 for singles this year but is now $56,800 for married filing jointly, up from $47,450.

While these and other related numbers will change yearly, the overall effect will be to allow more people, particularly married couples, to stay within the 15% bracket.

"That is something a lot of people may be shooting for," particularly in 2008, Tobias said.

A number of provisions in the books since 2001 should make the task easier.

For example, maximum allowable contributions to 401(k) plans and traditional IRAs, which don't count as taxable income, are rising gradually. For 401(k)s, the maximum goes up from $12,000 this year (or $14,000 for people 50 and over) to $15,000 in 2006 ($20,000 if 50 and over).

For IRAs, the $3,000 maximum this year ($3,500 if 50 and over) will rise to $5,000 in 2008 ($6,000 if 50 and over). In addition, income limits to qualify for fully deductible IRA contributions when covered by a retirement plan at work also are going up, and will be $80,000 for couples by 2007 and $50,000 for singles by 2005.