Investors and Tax Relief in 2003
For investors, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) makes two significant tax saving changes. First, corporate dividend income will now be taxed at long-term capital gains rates. Second, making this change even more favorable, long-term capital gains rates have been slashed by 5% for both taxpayers in the top four brackets, as well as those in the 10% and 15% brackets. While this legislation provides substantial reform for the next five years, it is scheduled to expire in 2009. Let’s take a closer look at the scheduled
changes and planning opportunities.
Prior to JGTRRA, investors who received dividend income were required to pay taxes at their marginal rate, which could be as high as 38.6%. Now, a dividend tax of 15% applies to taxpayers in the top four marginal brackets who receive dividend income. This provision expires in 2009.
For an illustration of the possible savings, consider the following hypothetical example of Claire Watson, who is in the highest tax bracket. Before JGTRRA, her annual dividend income of $50,000 would have been taxed at her marginal rate of 38.6%. Claire would have owed $19,300 in tax ($50,000 x 38.6%). While her marginal rate has been lowered to 35%, a new dividend tax rate of 15% applies to her dividend income. With this much lower rate, Claire experiences a significant reduction in her tax bill, owing instead only $7,500 ($50,000 x 15%)—that represents $11,800 in savings.
Lower income taxpayers are eligible for an even lower dividend rate. Investors in the 10% and 15% tax brackets will be subject to a dividend tax rate of 5%. For these taxpayers, the dividend tax will be eliminated altogether in 2008, and then be reinstated in 2009, when the legislation expires, at the prior rates of 10% and 15%, respectively.
Long-Term CapitalGains Cuts
Under JGTRRA, the long-term capital gains rate for investors in the top four brackets drops from 20% to 15%. Taxpayers in the 10% and 15% brackets will be subject to a 5% tax on long-term capital gains, reduced from 10%. These long-term rates apply to profits on the sale of capital assets held more than one year, and for transactions made on May 6, 2003, or later. This provision expires in 2009, when the former rate of 20% will again take effect.
Investors in the 10% and 15% brackets will experience a reprieve from long-term capital gains tax altogether in 2008, when it will be eliminated for one year. In 2009, the pre-JGTRRA rate of 10% will be reinstated. Short-term capital gains, which generally refer to investments held less than a year, will experience no tax reform, and therefore will continue to be taxed at the investor’s marginal rate.
This landmark tax cut bill provides a number of new planning opportunities for investors. For specific guidance, consult your qualified financial and tax professionals.
“Laddering” Fixed-Income Investments
Investors who are seeking regular returns and a promise of the return of principal often choose to include fixed income investments, such as bonds and certificates of deposit (CDs), in their portfolio. Conservative fixed-income investments, particularly government securities and federally insured CDs, are generally considered less volatile than other investment vehicles, such as common stock and, as a result, they tend to provide lower rates of return.
A portfolio that relies too heavily on fixed-income investments may be vulnerable to inflation or fluctuating interest rates. One technique commonly used to balance the return and risk of this particular asset class with an investor’s time horizon is laddering—a method of maintaining a series of fixed-interest investments with different maturities.
How It Works
With a “laddered” portfolio, fixed-interest investments come due in staggered
intervals at which time they may be cashed or reinvested. Because investments with shorter maturities generally have lower interest rates, laddering looks to provide an investor with the financial benefits of long-term interest rates, but the flexibility of shorter-term maturities.
Each investment acts like a rung on a ladder, so that rather than an investor taking one big step—such as investing in a single, long-term savings vehicle; he or she can take smaller steps toward long-term savings goals. Furthermore, stepped maturity dates may provide liquidity options that enable an investor to hold a security until its date of maturity, which may protect against early withdrawal penalties or a downturn in market value. For illustrative purposes, consider the following hypothetical example, which assumes no federal taxes or fluctuation in interest rates and does not represent the performance of any particular investment.
Janet Rydell wants to invest part of her savings in a portfolio that will provide
her access to her funds in the event she goes to graduate school. She chooses to deposit $10,000 into a laddered bond portfolio, and reinvest the principal until she needs the funds. To start, Janet splits her principal between five bonds, each with different maturities and interest rates.
Every year during the next five years, one of her bonds will mature. Upon maturity of the one-year bond, Janet pockets the interest earned and purchases a five-year bond with a higher interest rate that will mature in 2009. When her two-year bond matures, she takes the earnings as income and, with the original principal, purchases another higher yielding five-year bond, which will mature in 2010. While Janet is buying bonds with longer maturities and larger returns, one of her bonds will still reach maturity every year, providing her either access to her money, or the opportunity to reinvest.
Laddering offers fixed income investors a way to manage certain risks and add liquidity to their portfolios. When implementing any investment strategy, be aware that different securities have varying levels of risk. The principal value of bonds may fluctuate due to market conditions. If redeemed prior to maturity, bonds may be worth more or less than their original cost.
403(b) Plans: Beneficial Tax Law Changes
In 1958, the Internal Revenue Service (IRS) created 403(b) plans to encourage employees of certain organizations to begin saving for retirement. Organizations eligible for participation in these plans include those “organized and operated exclusively for religious, charitable, scientific, public-safety testing, literary, or educational purposes.” Paragraph (7) was added in 1974 by Congress, which gave
participants the right to invest in mutual funds as opposed to only insurance company investments.
In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) offered the most recent update on 403(b) plans, and provided several favorable changes to the rules and regulations.
A Closer Look
First, EGTRRA made the maximum amount contributable (MAC) calculation much simpler by negating the maximum exclusion allowance (MEA) calculation. Previously, this calculation was necessary to determine the annual contribution limit to a 403(b) plan. The MEA calculation required the computation of previous years’ contributions, which was often considered a burdensome task, especially for those who had changed jobs. With EGTRRA these rules have changed, and
now rules governing the maximum amount contributable allow contributions of:
- An elective deferral limit of $12,000 in 2003 (increasing to $13,000 in 2004); or
- As much as 100% of compensation, as long as that amount is less than the elective deferral limit; or
- Employer-sponsored contribution limits of the lesser of $40,000 (in 2003: $12,000 from the employee and $28,000 from the employer) or 100% of compensation.
- Those above age 50 may contribute an extra $2,000 for 2003 (increasing to $3,000 in 2004).
In addition, the 15- year-rule remains unchanged.
Under this rule, employees with 15 years of service for the same employer (not necessarily consecutive years) may contribute an additional $3,000 per year, if previous contributions were not higher than an average of $5,000. For those who qualify, this rule makes the annual contribution limit $15,000, which is the lifetime maximum under current laws.
It is also important to note that 403(b) plans are now eligible for rollover into a 401(k) plan as long as the following apply:
- The individual must be a 401(k) participant.
- Rollovers must be allowed in the 401(k) plan’s rules.
- Distributions from a 403(b) plan must be qualifiable, such as: death; disability; employment severance; or reaching [attainment of] age 59ó.
EGTRRA made several positive, legal changes in 403(b) plans, which are now more accessible than ever. However, there are also a few good, personal reasons to contribute to am 403(b). Although employees of qualifying organizations may be entitled to receive a pension at retirement, many find that pension proceeds are not as high as pre-retirement income. Contributions to a 403(b) plan can be a significant supplement to pension proceeds. Furthermore, 403(b) contributions are taken from gross pay and are made with pre-tax dollars, which means that all funds in a 403(b) plan grow tax deferred, and earnings accumulate without taxation until withdrawal. Withdrawals made before the age of 59ó may be subject to a 10% federal income tax penalty.
The combination of legal changes brought into effect by EGTRRA and the personal advantages of 403(b) plans make participation more appealing than ever. Don’t wait: Start participating in your plan today. After all, it’s your retirement.
Social Security Income Limits—Paying to Work?
If you’ve started collecting Social Security benefits and are still working, there are two factors that may be “working” against you. The first factor is the “giveback.” For 2003, if you are under full retirement age (65 to 67, depending on your year of birth), you will have to return $1 of benefits for every $2 earned in excess of $11,520. For the year full retirement age is attained, and until the actual month in
which it is reached, you will have to return $1 for every $3 earned in excess of $30,720 in 2003. There is no earnings limit requiring a giveback after reaching full retirement age. The second factor is the potential taxability of Social Security benefits.
Under current law, individuals with higher levels of earned income may be taxed on up to 85% of their benefits. For example, if modified adjusted gross income (MAGI) for Social Security purposes (generally all income including tax-exempt interest plus one-half of Social Security benefits received) exceeds $44,000 for those who are married and filing jointly, then up to 85% of benefits are included
in regular taxable income.
Relaxing the taxation of Social Security benefits has been discussed in Washington, but that issue has cooled somewhat in recent years, particularly as marginal rates initially dropped as a result of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and then again with the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Nevertheless, the issue of taxation on Social Security benefits bears careful watching by those who may be impacted by further changes.
At least for the immediate future, when you add up the regular tax on earned income, the FICA tax on wages (or self employment income), the potential “giveback” of benefits if you are under age 70 and still working, and exposing up to 85% of benefits to taxation, you may find that “paying for the privilege” of working may be a bit steep. If you really need the extra income, you may have little choice. On the othermhand, if you’re doing something you really enjoy, the tax costs may be a small price to pay for staying busy, being challenged, and feeling productive.