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