Sad to relate, most financial professionals take their eye off the tax ball. In fact, according to a study commissioned by Boston-based Eaton Vance Corp., clients are not getting the guidance they need and are entitled to receive from their advisors. The Eaton survey reveals that one-third of clients say their advisors rarely or never talk to them about the tax implications of their investments, and 29 percent say they have to raise the topic themselves. "Investors express concern about taxes and the tax implications of investing, but are confused by a subject that can, very quickly, become complicated," says Eaton Senior Vice President Duncan W. Richardson, adding: "There is a great opportunity for financial advisors to help their clients lower their tax drag by discussing tax basics and the implications of recent tax legislation."
Richardson was referring to President Bush's 2003 tax package, the centerpiece of which was a decrease from 20 percent to 15 percent in the top rate for long-term capital gains from sales of individual stocks, shares of mutual funds and most other invest-ments owned more than 12 months. The reduction stays on the books through 2010, when it is due to end. Those who benefit the most from the top rate of 15 percent are individuals in the four highest regular income tax brackets--25, 28, 33 and 35 percent. For 2007, the 25 percent bracket applies to taxable income of at least $31,850 for single filers and $63,700 for joint filers. For 2008, the numbers are $32,550 and $65,100.
The top rate for long-term gains also fell--from 10 percent to 5 percent for those who fall into the two lowest regular brackets of 15 percent and 10 percent. For single filers, that means taxable income below $31,850 for 2007 and $32,550 for 2008; for joint filers, below $63,700 for 2007 and $65,100 for 2008. That reduction applied just through 2007, and decreases from 5 percent to zero for years 2008 to 2010.
To add to the already mind-numbing complexity of the tax code, the six regular brackets change yearly because they are indexed for inflation. The IRS annually adjusts the taxable income level at which the brackets start and end. The rationale for indexing: Relief from so-called bracket creep--enrichment of the government at the expense of individuals pushed into loftier brackets even though their incomes only stay even with inflation, thus eroding their actual, after-tax income.
The 2003 act also reduced tax rates on what the law designates as "qualified dividends." As a general rule, these are dividends from stocks and stock funds. Like long-term gains, dividends are taxed at a top rate of 15 percent for individuals in the 25 percent bracket or higher and at 5 percent for those in the 15 percent bracket or lower, dropping to zero for 2008 to 2010.
Contrary to what many investors mistakenly believe, the 2003 legislation did not lower capital-gains rates for all assets. A key exception are long-term gains from sales of art works, gems, antiques, stamps, coins and other so-called collectibles, which remain at 28 percent--close to double the top rate for securities.
The 2003 act left unchanged a maximum rate of 25 percent for long-term gains from sales of real estate attributable to depreciation. The 25 percent rate applies to individuals who invest directly in commercial properties, including apartment buildings and motels, and indirectly through REITS that own baskets of real estate--everything from apartments to office complexes to hospitals and shopping centers. Then the 15 percent rate kicks in, which might encourage some investors to dispose of long-held real estate.
The top rates of 15 and zero percent for capital gains and dividends are scheduled to "sunset" (that is, expire) after 2010, which just happens to be a Congressional election year. As of now, the rules for 2011 and ensuing years require long-term gains to be taxed at rates of 20 percent and 10 percent, and dividends to be taxed at ordinary income rates that go as high as 39.6 percent--just as they were taxed before passage of the 2003 legislation. In order to prevent that from happening, Congress and whoever occupies the Oval Office must cut a deal to extend the reductions into 2011 and beyond--or make them permanent.
Meanwhile, the rates that start at 10 percent and go as high as 35 percent for ordinary income continue to apply to interest received from government bonds, and "dividends" (considered interest) paid on savings accounts, certificates of deposit and other savings vehicles. Similarly, neither the reduced rates for dividends nor those for long-term capital gains applies to withdrawals, whether voluntary or required, from traditional IRAs, 401(k)s, annuities and other tax-deferred retirement plans. It makes no difference that such withdrawals are attributable to dividends paid on stocks held in the accounts or capital gains derived from sales of such stocks; the ordinary-income rates apply to all the above. No wonder some investors might perceive that as a disincentive to moving more money into retirement accounts.
Dramatic rate reductions for long-term gains and dividends also benefit investors in mutual funds that distribute capital gains and dividends to their shareholders. But there is no rate reduction for distributions of interest, which is still taxed as ordinary income, just as are salaries.
Of course, the taxing authority deems some dividends to be more deserving than others. IRS regulations require 1099 information forms to identify payouts as: (1) qualifying for reduced rates of 15 percent or 5 percent because they come solely from dividends paid by stocks in a fund's portfolio; or (2) not qualifying for lower rates because they actually are attributable to interest from bond funds and money-market-funds or from short-term capital gains, for instance. Those kinds of "dividends" are taxed at ordinary income rates of from 10 percent to 35 percent.
Do you plan to sell shares of mutual funds held in taxable accounts? To accurately determine whether sales generate gains or losses, make sure that the shares' cost bases are adjusted upward to reflect all automatic reinvestments of dividends and capital gains distributions. Only when all of those previously taxed items are included, can you be certain that they do not overstate reportable income or understate deductible losses.
The fundamentals still apply. In general, investors out to maximize deferral possibilities should avail themselves of traditional IRAs and other tax-deferred retirement plans to hold taxable bond funds or equity funds whose managers trade frequently, thus incurring short-term gains. Consistent with that approach, for the most part investors ought to use taxable accounts to hold shares of mutual funds that generate dividends and long-term capital gains.
However, investors need to run the numbers to see if these allocations are appropriate. Moving too much money into tax-deferred plans can result in a bigger hit with more overall taxes when they take money out. In any case, you should see that your clients' decisions on what types of investments are best held inside or outside of such plans jibe with their risk tolerance and investment aspirations.
The reduced rates for long-term gains and dividends also apply to calculating the alternative minimum tax. The lower rates for ordinary income, long-term gains and dividends mean the AMT is going to snare a steadily growing number of individuals, diminishing any benefit from the reductions. The hit list includes investors with substantial amounts of long-term gains and dividends taxed at a top rate of 15 percent, especially those who file in high tax areas on the East and West Coasts like California, Connecticut, Maryland, Massachusetts, New Jersey, New York, Oregon and the District of Columbia. Remember, state and local income and property taxes are among the itemized deductions that are not allowed for AMT purposes.
To figure an investment's holding period, begin the count on the day after acquiring the property and include the date of sale. For example: When shares of stock are bought on July 8, the holding period starts to tick away beginning July 9. The ninth of each following month is the beginning of a new month. If the shares are sold on July 8 of the next year, the holding period is less than 12 months and the capital gain or loss is short-term. If they are sold on July 9, the holding period is more than 12 months and the gain or loss is long-term.
When it comes to sales on the New York Stock Exchange or other established securities markets, the sale date is the trade date when an investor orders the sale's execution, not the later settlement date when sales proceeds are received and shares must be turned over.
The rules for mutual fund shares are similar. The measure of the 12-month holding period is from the record date of a purchase to the record date of a redemption. These trade dates are the dates that funds actually transact shareholders' authorizations to buy and sell shares. Funds report these dates on their confirmation statements.
But the measurement is not that straightforward when shareholders authorize automatic reinvestments of dividends, as is the norm. The complication occurs because a reinvestment results in the purchase of a separate lot of shares, with a shorter holding period and different cost basis than the original investment.
But the harshest rules are reserved for short-term gains from investments owned less than 12 months. They are taxed at rates as high as 35 percent for "ordinary income." This includes income from salaries, business profits, withdrawals--whether required or voluntary--from traditional IRAs (including conversions that move funds from traditional IRAs to Roth IRAs), 401(k)s and other tax-deferred retirement plans; rental income and interest. For someone in the 35 percent bracket (2007 taxable income above $349,700) who realizes a profit of $100,000 from selling shares, the tab of $35,000 for a short-term profit shrinks to $15,000 for a long-term profit.
The revised rules increased the difference between the highest tax-bracket rate for ordinary income and the highest rate for capital gains and dividends. The difference went from 18.6 percentage points (38.6 minus 20) to 20 percentage points (35 minus 15), making it even more advantageous for higher-bracket taxpayers to realize long-term gains and dividends instead of short-term gains or interest and other ordinary income.
The difference might motivate some clients to move money out of bonds and bond funds and into individual shares of companies with histories of declaring dividends and stock funds that invest in such companies. Still, it would be unwise for investors to make these decisions on the basis of tax considerations alone. They ought not to overlook companies with more modest dividend yields but better growth prospects.
Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books is at julianblocktaxexpert.com.
