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Some Common Investments Enjoy Preferential Tax Treatment

Although there are a variety of sophisticated tax shelters available, our tax laws also afford special tax treatment to certain common types of investments. Used appropriately in conjunction with sound tax and investment planning, these special benefits may produce a higher after-tax return on your investment dollars.

Dividends: Beginning in 2003, dividends received by an individual shareholder from domestic corporations (and certain foreign corporations) are treated as net capital gain for purposes of applying the capital gain tax rates. This means dividends are taxed at 15% for taxpayers whose marginal rate is above 15% and 5% for those in the 10% and 15% Tax Brackets. This net tax savings for each marginal tax bracket is illustrated below.

Dividend Rate
Net Tax

Even though dividends are taxed on the Schedule D, dividend income cannot be offset with capital losses. Dividends on stock held in a retirement plan or traditional IRA will not benefit from the new lower rates; distributions from these plans continue to be taxed at ordinary income rates.

Municipal Bonds: Although they generally pay a lower interest rate, their "after- tax" return can be higher than other similar investments such as corporate bonds, CDs, etc. Taxpayers in higher tax brackets and children subject to the "kiddie tax" frequently use this investment. If your state has income tax, you should note that most states will only allow the exclusion of interest on municipal bonds issued from that particular state. Municipal bonds can be purchased directly or investments can be made through a variety of municipal bond funds, many of which specialize in bonds from a specific state. Taxpayers drawing Social Security benefits should be reminded that even though municipal bond income may be tax-free, it is still used as income for purposes of determining the taxable portion of Social Security income.

Capital Gains: Gain from investments such as stocks, mutual funds, land, real estate, etc., are taxed at rates lower than an individual's regular tax rate if they are held over one year. Gains from such assets are taxed at 10% if you are in the 15% tax bracket or 20% if you are in the 28% or higher tax bracket. Assets held over five years get an even bigger break. There are exceptions to the requirement to hold the asset over one year in order to receive the beneficial long-term treatment. If the asset is a gift, your holding period includes the holding period of the giver, and if the asset is inherited, it is always treated as long-term.

Interest for Direct U.S. Government Obligations: This category includes U.S. Savings Bonds, T-Bills, H Bonds, etc. Interest earned on these obligations is taxable only for Federal purposes. Federal law prohibits states from taking a bite out of this income. Taxpayers that wish to reduce their state tax liability will greatly benefit from these investments. In addition, Savings Bond interest can be deferred until the bonds are cashed or reach maturity, providing a valuable tool for deferring income to some future tax year. Children, who are still dependents of their parents and have a lower standard deduction, can use the bonds to defer their income to a year when they get benefit of the full standard deduction, personal exemption, and lower tax rate. If that same child attends college, they may be able to offset the income with education credits.

Education Savings Bonds: Interest you receive from the redemption of U.S Series-EE savings bonds purchased after 1989 and after attaining the age of 24, held in your name or jointly with your spouse, may be excluded from income to the extent you pay qualified higher education expenses. The expenses must be for you, your spouse or a dependent and must have been paid during the same year the bonds were redeemed. The tax benefit has limited application since the benefit is phased out for taxpayers with higher incomes. Generally, the phase out begins around $52,000 for singles and $78,000 for those filing jointly. The exclusion is completely phased out by the time singles reach about $68,000 and $108,000 for joint filers. If you are considering this strategy, keep in mind the income phase-out is based on the year the bonds are redeemed and not the year they are purchased.

If we can assist you with the application of any of these strategies to your particular situation, please give us a call.

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