Some savings are automatic, but you can pile on others by using your ingenuity.
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Some savings are automatic, but you can pile on others by using your ingenuity.
One day last month, Dr. Turner made a frantic call to his accountant. "You told me I wouldn't be eligible for a child tax credit in 2003 like I was in 2002, but I just got an advance rebate check from the IRS for $500. What should I do?"
"Cash it," the accountant said.
"And go directly to jail?"
The accountant laughed. "Relax. The new tax law says you can keep the rebate even if you're not entitled to the credit this year."
That's just a sample of the quirky provisions in the law. Here's a summary of the major changes that will affect your tax bill this year and could shape your financial planning for the period ahead. These revisions are retroactive to January 1, 2003, unless otherwise noted:
Lower rates on regular income. The former top-bracket rate, 38.6 percent, drops to 35 percent. The 35, 30, and 27 percent brackets each fall 2 percentage points.
Bigger child tax credit. The credit jumps $400 for each child under 17 in 2003 and 2004 (to $1,000), but slips back $300 (to $700) in 2005.
Dividend and long-term capital gains tax cuts. The new maximum rate on both falls to 15 percent through 2008, but timing is an issue. The new capital gains rate applies only to sales made on or after May 6, 2003, and you must have held the securities for more than a year. To get the dividend tax break you must hold securities for at least 60 days during a specific period surrounding the ex-dividend date (the date before which stockholders must own their shares in order to collect dividends).
Looser restrictions on business deductions. From 2003 through 2005, most medical practices will be able to write off a much larger proportion of the cost of new equipment, machinery, and certain other property.
This synopsis looks fairly simple, but the devil is in the details. So are some benign angels. Adding to the complexity is the fact that the various cuts will expire on different dates. Your present age, family circumstances, and financial outlook will determine the best strategy for wringing the maximum savings from the law. The illustrations that follow will help guide your planning.
In 2002, Dr. Farrell and her husband paid $24,036 in tax, based on joint adjusted gross income of $134,000 and taxable income of $112,000. With the same income in 2003, the tax rate in their top bracket will drop from last year's 27 percent to 25 percent, and they'll also benefit from declining rates in the lower brackets. All told, those cuts add up to a reduction of about $2,400, but their actual tax saving will be higher.
The Farrells, who are in their mid-30s, have two youngsters. In 2002, a married couple with two children eligible for the child tax credit could claim a maximum of $1,200$600 for each child. But such a couple also lost $50 of their total credit for every $1,000 of AGI above $110,000. So the Farrells' $134,000 AGI reduced their 2002 credit to zero ($50 x 24 = $1,200). The same AGI this year will also cost them $1,200 of credit, because the new law doesn't raise the phaseout threshold. But it raises the credit to $1,000 per child. That will allow the Farrells to claim $800 ($2,000 $1,200).
Unlike Dr. Turner, they won't receive a rebate check this year, since they weren't able to claim any credit on their 2002 return. But they can subtract the credit from their tax bill when they file for 2003. Therefore, their total tax saving will come to $3,200.
Their good fortune can continue, though. Before the tax law passed, Dr. Farrell felt she couldn't afford to defer more than $9,000 of salary to her 401(k) plan this year. The extra tax money will let her make the maximum $12,000 deferral for 2003. This would trim the couple's taxable income by $3,000, yielding an additional saving of $750 in their 25 percent tax bracket under the new law. As icing on the cake, the lower AGI would increase their child tax credit an extra $150.
Should the Farrells invest the 401(k) plan contribution in high-dividend stocks, to take advantage of the lower tax rate on dividends? That's a dubious move. The dividends won't be taxed until they're withdrawn from the plan, and the Farrells' regular rate will apply to all withdrawals, as was the case under prior law. Similarly, profits on plan investments won't qualify for the reduced capital gains rate. But that reduced rate can make diversification into growth investments outside a retirement plan more attractive for couples like the Farrells, once they've reached the legal limit on deductible retirement contributions.
A note of caution: The 15 percent capital gains rate cut only partially covers real estate profits. Say you bought a rental property for $200,000 and have claimed $40,000 in depreciation on it, lowering your tax cost basis to $160,000. If you now sell it for $250,000, your taxable capital gain will be $90,000. You'll owe 25 percent on $40,000 due to the depreciation deductions, and 15 percent on the $50,000 balance.
If you're a somewhat older doctor and already have sizable investment holdings outside your retirement plan, you can choose from a tempting menu of new tax breaks. But take care to read the fine print.
Although the tax rate on dividends and on long-term capital gains is now the same, the two types of income aren't interchangeable. Dividends are taxed the year you receive them, leaving less for reinvestment, but you don't pay tax on a gain until you sell the asset. So even if the pre-tax returns are equal, the rate of compounding isn't. With an investment horizon of 15 or 20 years, the capital gains edge widens, especially if you hang onto the shares of highly successful companies that leverage profits to accelerate growth instead of distributing most of them to shareholders.
Of course, if your existing portfolio already pays sizable dividends, you'll enjoy a hefty tax benefit. The 15 percent bite on them is well under the 28 to 35 percent you'll probably owe on other income. Incidentally, don't try to offset dividend income by selling a holding to create a capital loss. This ploy would save the 15 percent tax on a long-term capital gain, but the law won't let you treat dividend income that way, even though the tax rate is the same.
In any event, you're better off if you don't try to offset long-term gains with losses. You can deduct up to $3,000 of a loss against more heavily taxed regular income (or short-term gains) in a year when you don't have a long-term gain. If you're in the 35 percent bracket, say, your capital loss would save you $1,050, compared with just $450 from offsetting a long-term gain. Losses exceeding $3,000 carry over to future years.
If you're still in midcareer, other changes in the law may prove unexpectedly bountiful. Dr. Sherman, a 50-year-old specialist in sports medicine, had planned to spread $250,000 in purchases of state-of-the-art physical therapy equipment over a period of several years, because of limits on how much he could write off each year. The new law will let him modernize a good deal faster.
Normally, you can claim a one-shot ("Section 179") deduction in the year you purchase and start using the equipment$24,000 was the maximum in 2002and depreciate the balance in five or seven years. Previously, though, the full Section 179 deduction was available only if your total equipment expense didn't top $200,000 for the year. The new law lifts that annual ceiling to $400,000 for 2003 through 2005. Better yet, it expands the Section 179 deduction limit to $100,000 in each of those years. The $100,000 and $400,000 will also be indexed for inflation in 2004 and 2005.
Even if your equipment needs are more modest than Dr. Sherman's, you may get a windfall from another provision in the new law. If you bought a new car for use in your practice after May 5, 2003, or you plan to buy one, you can write off as much as $10,710 of its cost the first year. Better yet, if the car weighs more than 6,000 pounds you can claim the entire cost at once, as part of the $100,000 Section 179 deduction. But buy the car before the end of next year, or your coach may turn into a pumpkin. After 2004, this tax break expires, and the cap may revert to $3,060.
At age 60, Dr. Horton expects to quit practice in five years or somaybe sooner if his health problems worsen. Outside his pension plan, he has a $500,000 stake in growth mutual fund shares. He also owns $300,000 in gilt-edged bonds and certificates of deposit, yielding an average of 6 percent, or $18,000, in fully taxed interest. In the 33 percent bracket, he'll be left with $12,060 after taxes.
Suppose he replaces his fixed-income holdings with securities paying the same income in the form of dividends taxed at 15 percent. This would raise the after-tax yield to $15,300, a difference of $3,240. If compounded for 10 years, assuming no change in those annual figures, the shift would add more than $40,000 to Horton's nest egg.
However, the special dividend rate is scheduled to expire after six years. Even if it's extended, the doctor's top tax bracket may decline in retirement to 25 or 28 percent, shaving some of the dividends' tax advantage. In view of this uncertainty, he's reluctant to leave the safety of his present fixed-income portfolio.
Instead, Dr. Horton can test the water by gradually replacing part of his growth fund portfolio with shares in funds holding mainly stocks that are likely to declare generous dividends. An important caveat: Mutual funds sometimes realize short-term gains from the sale of their holdings and distribute them as dividends to fund shareholders. Such dividends continue to be taxed as ordinary income under the new law; the 15 percent dividend and capital gains rates don't apply.
Most dividends declared by real estate investment trusts (REITs) are likewise ineligible for the 15 percent rate, because REITs don't pay corporate taxes on earnings from their operations if they distribute the income to shareholders. However, if a REIT passes profits from the sale of property on to shareholders, they're taxed in accordance with the real estate capital gains rules explained previously.
In contrast, dividends on common stocks will almost always qualify for the 15 percent rate. The main requirement is that the company involved is subject to tax on the money distributed to shareholders. Dividends on preferred stock also qualify, unless the issuer treats them as deductible interest. Note that interest received by money-market or bond funds on their investments in debt securities and then passed along to you doesn't qualify even if it's labeled a dividend.
Normally, preferred stocks pay substantially higher dividends than common stocks, and common shareholders get no dividend until outstanding obligations on preferred shares are met. However, the preferred dividend is usually fixed, whereas common dividends can increase over time if the company prospers and wants to attract tax-sensitive investors.
Earlier in 2003, for instance, Bank of America preferreds were yielding around 6.4 percent, compared with 3.2 percent for the common. But in June the company increased the common dividend to 4 percent. It remains to be seen whether this foreshadows a trend that will gather force. Meanwhile, if you're a cautious investor, you may lean toward a wait-and-see policy.
On the other hand, your grandchildren might thank you for moving faster to nail down the lower tax rates the new law offers. If they have little or no income of their own and you put securities in their names, they'd pay no more than 5 percent on taxable dividend distributions or capital gains from 2003 through 2007. Still more enticing, in 2008 the rate drops to zero (yes, zero). But after that, these low-bracket tax breaks are slated to disappear. Two points to bear in mind:
The bargain rate is available only in years when a child is at least 14. If a younger child's income from securities tops $1,500, the excess will be taxed at 15 percent, the same rate the child's parents would pay.
The child's capital gain on the sale of the gift will be based on your cost, if that's greater than the market value when you made the gift.
One more temporary tax break an older married doctor shouldn't overlook: The new law raises the standard deduction on a joint return more than $1,500to $9,500for 2003 and likely a bit higher for 2004. (It will probably fall back to less than $9,000 in 2005.) That may tip the scales in favor of not itemizing this year and next. If the decision is close, consider delaying some personal deductions until the following yearcharitable contributions, for example.
Can lower rates be too much of a good thing? Maybe so, if they slash your regular tax bill to the point where you'll be subject to the fearsome alternative minimum tax. Once that tax kicks in you must add back to your taxable income many itemized deductionsincluding those for property taxes, some interest on home equity debt, and most miscellaneous expensesbefore applying a rate of either 26 or 28 percent to figure the tax.
Congress paid lip service to this threat by raising the AMT exemption for 2003 and 2004 to $58,000 on a joint return, up from $49,000 under the old law; for single filers, the exemption rises from $35,750 to $40,250. But the exemptions start shrinking if joint AGI tops $150,000 ($112,500 for singles).
A second negative possibility is that your state tax may increase in some circumstancesfor instance, if you go in heavily for dividend income to save federal tax, but your state continues to treat it as fully taxable. Ironically, if you then fall prey to the federal AMT, you'll lose your deduction for taxes you pay the state.
The bottom line is that increased AMT exposure won't nullify the benefit of the new tax cuts, but it may call into question some proposed financial actions they might otherwise lead you to take. Rather than pursue promised savings blindly, consult your tax adviser first.
Lawrence Farber. New tax law, new tax savings. Medical Economics Sep. 5, 2003;80:74.