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On May 28, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003, the third-largest tax cut in U.S. history and the third in the last three years. The act includes many temporary provisions and many new tax rates that affect virtually every individual, as well as many businesses.

With the complications of scheduled tax changes as well as additional tax legislation that will certainly follow, proper tax planning is crucial. In addition, the act raises many new opportunities within what will continue to be an even more intricate tax environment. Current and long-term planning will consequently take on a new dimension.

This article highlights the key provisions of the act, describes the impact on individuals, and identifies specific tax planning strategies designed to take advantage of the opportunities that the act creates.

Note that, with the exception of the May 6 effective dates for the reduction in tax rates on capital gains and for the increase in bonus depreciation, all of the other provisions presented here are retroactively effective Jan. 1, 2003. Unfortunately, in order to pacify certain members of Congress, all the favorable changes are subject to so-called sunset rules. Consequently, unless Congress takes further action, all of the described tax breaks will expire in future years. With these thoughts in mind, below are the key planning strategies for individuals created by the act.

Income Tax Reductions

The reductions in income tax rates in excess of 15 percent, originally scheduled for 2004 and 2006, are accelerated to 2003, resulting in new rates of 25, 28, 33 and 35 percent (from 27, 30, 35 and 38.6 percent, respectively). These reductions benefit married couples with taxable income greater than $47,450 and single taxpayers with taxable income greater than $28,400. After 2010, unless the law is changed again, the income tax rates will revert to the pre-2001 act rates of 15, 28, 31, 36 and 39.6 percent.

Even if the other changes created by the act (and described below) do not apply, all taxpayers with income in excess of the above-referenced thresholds will pay lower income taxes in the form of lower withholding, a smaller tax balance due, or a larger refund. If the reduction in the income tax rates is reflected by lower withholding, consider using the increase in net take-home pay to pay down debt on which nondeductible interest is paid, or to contribute additional funds to a qualified plan or IRA account, or to contribute larger amounts to tax-favored qualified tuition programs (Section 529 plan), or simply invest it. If the reduction in the income tax rates is reflected by lower estimated tax payments, consider using the funds previously used for the estimates for the same purposes.

Reduced Dividend Tax

The maximum tax rate on qualified dividends paid by corporations to individuals and on individuals’ capital gains is reduced to 15 percent in 2003 through 2008. For taxpayers in the 10 and 15 percent ordinary income tax rate brackets, the rate on dividends and capital gains is reduced to 5 percent in 2003 through 2007, and to zero in 2008. The new rates apply to qualified dividends received in tax years beginning after 2002, and to capital gains realized (and installment payments received) after May 5, 2003. However, unless there’s another law change, the new dividend and capital gains tax rates will end in 2008.

Not all dividend income is “qualified dividend income.” For example, certain dividends paid by regulated investment companies (mutual funds) and by real estate investment trusts (REITs) are taxed at the maximum rate for individuals. The act provides that for any taxable year that the aggregate qualifying dividends received by the mutual fund or the REIT is less than 95 percent of its gross income (as specially computed), the amount of dividends qualifying for reduced rates may not exceed the amount of the aggregate qualifying dividends received by the mutual fund or the REIT. In addition, only dividends paid on common stock held by a shareholder for more than 60 days during the 120-day period beginning 60 days before the ex-dividend date is considered “qualified dividend income,” and this holding period requirement is increased for preferred stock to 90 out of 180 days.

Capital gains that qualify for the new, lower 15 percent rate do not include collectibles (e.g., stamps, coins) gain, Section 1202 gain (qualified small business stock), or unrecaptured Section 1250 gain (depreciation recapture). Collectibles gain and Section 1202 gain are taxed at 28 while unrecaptured Section 1250 gain is taxed at 25 percent.

Dividends that qualify for the 15 percent tax rate are no longer considered investment income for purposes of deducting investment interest unless an election is made to have the dividend income taxed at the regular income tax rates. This rule prevents a taxpayer from deducting investment interest against the new top rate of 35 percent while simultaneously taking advantage of the new 15 percent dividend and long-term capital gain rate. Taxpayers can elect to include as much of the dividend income in investment income as they choose as long as they reduce the amount of dividend income eligible for the 15 percent rate by the same amount. Therefore, if more tax is saved by deducting investment interest than by having all qualified dividend income taxed at the new, 15 percent rate, the election should be considered.

For an individual now in the 35 percent tax bracket, as a result of the act, dividends paid by any mutual fund are taxed, in general, at that rate. Qualified dividends paid by a corporation, however, are only subject to the 15 percent rate created by the act. Therefore, a mutual fund paying a 10 percent dividend will net, after taxes, a 6.5 percent return. A qualified dividend paid by a corporation with a dividend rate of 7.65 percent or better would yield a better after-tax return, since that dividend is only subject to the 15 percent income tax rate. Therefore, consider shifting investments out of mutual funds, subject to tax resulting from the sale if there is a gain, and into corporate stock in order to take advantage of this change in the law.

Taxpayers with appreciated securities should consider transferring them to children over age 13 (to prevent the application of the “kiddie tax”). Savings in 2008 would be dramatic upon sale of the appreciated securities, assuming the child was in the 15 percent bracket, since, for 2008 only, the 5 percent capital gains tax rate for low-income taxpayers drops to zero. Similarly, if the assets are not sold, but are generating dividend income, the income tax rate for dividends, for that one year, is also zero. When transferring, however, there may be gift tax consequences.

Be cautious, though. To the extent that appreciated securities are transferred to children under 14, it may be prudent that the child not sell the appreciated securities until the child reaches age 14, or the benefit of the 5 percent rate will be lost to the kiddie tax, which taxes the child’s unearned income above 15 percent at the parent’s top tax rate of up to 35 percent. However, investment decisions should be based not only on tax considerations, but also on economic factors.

Consider shifting a portfolio investment blend by putting more dividend-producing equities in taxable accounts and more interest-producing investments in tax-deferred retirement or IRA accounts. Only the 15 percent income tax will be paid on the qualifying dividends, while the amounts that are distributed from tax-deferred retirement or IRA accounts will be treated as ordinary income subject to regular income tax rates as high as 35 percent, regardless of whether the assets in the retirement account are debt or equity securities. In addition, the investments that yield interest income may have to increase their rates in order to compete with the new, tax-advantaged treatment of dividend income, so those tax-deferred retirement or IRA accounts may generate more income than they were prior to the act. However, since the 15 percent income tax on qualified dividend income is subject to expire after 2008, that six-year period may not be long enough for a change in investment strategy to have a material effect on your overall financial position.

Married Couples

The standard deduction (the deduction for taxpayers who do not itemize their deductible expenses) for married couples is increased to double the amount of the standard deduction for single taxpayers in 2003 and 2004. Also, the width of the 15 percent tax bracket (the maximum amount taxed at 15 percent instead of the higher rates) for married couples is increased to twice the width for single taxpayers in 2003 and 2004. These provisions were originally scheduled to phase-in over the period between 2005 and 2009. These reductions benefit married couples who claim the standard deduction as well as those who have taxable income greater than $47,450.

Both of these provisions are effective only for 2003 and 2004. After 2004, unless the law is changed, the standard deduction for married couples will decrease (e.g., to 1.74 times the standard deduction for single filers for 2005) and then gradually rise, until in 2009 it will once again be double a single taxpayer’s standard deduction. Similarly, the width of the 15 percent tax bracket for married couples after 2004 is reduced to 1.80 times the width of the 15 percent tax bracket for single filers in 2005. It will then gradually rise, until 2008 when it will once again be twice the width of the 15 percent tax bracket for single filers.

If the standard deduction for 2003 or 2004 exceeds deductible itemized deductions for the same year, but the situation is expected to reverse in the other year, use the “bunching” technique. This entails, to the extent practical, “bunching” itemized deductions, such as charitable contributions or state and local income taxes, in the year in which itemized deductions exceed the expanded standard deduction for married couples. The result is that taxable income for both years is minimized.

Child Tax

The amount of the child tax credit is increased to $1,000 in 2003 and 2004 (from $600), accelerating a scheduled phase-in over the period between 2005 and 2010. In 2003, the increased amount of the child tax credit began to be automatically paid by the IRS in advance in July 2003 on the basis of information on the taxpayer’s 2002 tax return filed in 2003. Advance payments are being made in a manner similar to the advance payment checks that were issued in 2001 to reflect the then new, 10 percent tax bracket. Since the advance payment is treated as a refund of an overpayment, it is subject to refund offsets such as back taxes, student loans, or past-due child support obligations.

Taxpayers do not have to take any action to receive the advance payment, which is being mailed based on the last two digits of the Social Security number listed first on the 2002 tax return, so that taxpayers with the lowest last two digits of their Social Security numbers will receive their checks first. The credit is still phased out starting at an adjusted gross income of $75,000 for single filers and $110,000 for joint filers, so many higher-income taxpayers who did not qualify for the credit under old law will not qualify this year, either.

If a 2002 income tax return has not been filed, and the taxpayer qualifies for the child tax credit for 2002, the return should be filed as soon as possible. Only taxpayers who have filed their 2002 income tax returns will receive the advance payments. On the other hand, some taxpayers who receive the advance payments will find that they no longer qualify for the tax credit in 2003, due to an increase in their income. The act provides, however, that the amount of child tax credit that would otherwise be allowed for the taxpayer’s first taxable year beginning in 2003 must be reduced (but not below zero) by any advance payment made to the taxpayer. The act also provides that the advance payments will be computed based on the ages, as of Dec. 31, 2003, of the dependents that qualified for the child tax credit. Consequently, a dependent who was 16 as of the end of 2002 will not be included in the computation of the advance payment, since he or she will be 17 as of the end of 2003.

AMT Exemptions

Alternative Minimum Tax (AMT) Hold-Harmless Relief: To ensure that the benefits from the acceleration of the tax reductions are not reduced by the AMT, the AMT exemption amount is increased by $9,000 (up to $58,000 from $49,000) for married taxpayers and by $4,500 (up to $40,250 from $35,750) for single taxpayers in 2003 and 2004. The new tax rates on dividends and capital gains are effective for both regular income tax and AMT purposes. Unless Congress takes further action, the exemptions for 2005 and later years will revert to $45,000, $33,750, and $22,500.

However, the point where the AMT exemption begins phasing out ($150,000 on a joint return and $112,500 for unmarried individuals) has not been changed. Thus, even though the exemptions are larger, they will still be unavailable for many higher-income taxpayers.

Consider making accelerated payments of items deductible for regular income tax purposes, such as state and local income taxes or miscellaneous itemized deductions. As long as those items, along with any other AMT adjustments, do not negate the effect of the higher AMT exemption, your regular income tax liability will exceed your AMT liability, so you will receive a tax benefit for those accelerated payments.

Furthermore, if you have typically been subject to the AMT, the higher AMT exemption created by the act for 2003 and 2004 may provide an opportunity to obtain a credit for a previously paid AMT. That is because when current-year regular income tax liability exceeds current-year AMT liability, previous years’ AMT liabilities are fully, or partially, treated as a credit for regular income tax purposes, if the AMT was the result of “deferral” items such as accelerated depreciation or the exercise of incentive stock options. An AMT credit will result, and at least a portion of your previously paid AMT will increase an overpayment, or reduce a balance due, on your income tax return.

Conclusion

The 2003 act is relatively brief and contains none of the special interests or technical correction provisions found in traditional tax bills. Yet, for individual taxpayers who fit within the new law’s sweet spot (such as married taxpayers with children under the age of 17, investors, and high-income individuals), the strategies that can generate tax savings are plentiful.

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