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Financial
REDUCING YOUR TAX BILL
By Steven E. Levitsky
It’s too late to do much for 2003, but you’ve got plenty of opportunities to take advantage of tax-advantaged investment strategies for 2004.
Of course, there is a fair chance you don’t view your tax situation as all that bad. After all, nearly three out of four taxpayers will receive refunds this year. Through mid-March of this year, the IRS had mailed about 52 million federal tax refunds, totaling nearly $112 billion – an average refund of $2,151. If you’ve gotten a refund, you can use the money to help your tax situation for 2005 and potentially improve your investment outlook for years into the future.
For example, why not use your refund to help fund a traditional or Roth IRA? For 2004, you can contribute up to $3,000 to your IRA, or $3,500 if you’re 50 or over. Depending on your income level, your contributions to a traditional IRA may be tax-deductible – and, in any case, your earnings will grow on a tax-deferred basis. If you invest in a Roth IRA (using non-deductible dollars), your earnings grow totally tax-free, provided you’ve had your account for at least five years and you don’t make withdrawals before you reach 59 ½.
Apart from contributing to your traditional or Roth IRA, what other steps can you take to become a more tax-conscious investor? Here are a few to consider:
Invest in dividend-paying stocks
Until 2003, stock dividends were taxed at your individual tax rate. But in 2003, changes in tax laws lowered the maximum dividend tax rate on qualified stocks to 15 percent (expires Dec. 31, 2008). So you may want to add some high-quality, dividend-paying stocks to the growth-and-income portion of your investment portfolio. Try to find those stocks that have had a long history of paying and raising dividends.
If you were in the 36 percent tax bracket in 2002, for example, you would have paid $900 in taxes on $2,500 of dividend income. But last year, because the tax rate on qualified dividends was cut to a maximum of 15 percent, you would have been taxed just $375 on the same $2,500, giving you additional after-tax income of $525.
Which dividends qualify? For the most part, the dividends paid by domestic stocks will be taxed at the new, lower rate unless you keep them in a tax-deferred account, such as a traditional IRA. In that case, while you will still benefit from tax-deferred earnings, when you eventually take withdrawals (usually during retirement), your distributions will be taxed at your ordinary income tax rate (distributions taken prior to age 59 ½ are subject to a 10 percent early withdrawal penalty). Keep in mind that the new, lower rate on dividends is currently set to expire by 2009, when dividend taxes are scheduled to revert to ordinary income tax rates.
Apart from their tax advantages, dividend-paying stocks can offer you at least three other potential benefits:
· Diversification – If your equity holdings are dominated by growth-oriented companies, you can add balance and help diversify your portfolio with growth-and-income stocks.
· Potential to increase shares owned – If you don’t need your dividend income to pay your bills, you can reinvest it in additional shares (transaction fees may apply), thereby putting more money to work toward your long-term goals.
· Improved portfolio quality – Stocks that have long histories of paying dividends and regularly increasing them are often well-run companies with strong management, good business plans, and competitive products. High-quality, blue–chip stocks can help strengthen the quality of your portfolio.
Of course, it’s never a good idea to base investment decisions solely on tax considerations. Quality and diversification should always be top priorities. As you consider investments to provide income, there are very distinct advantages to fixed-income investments like bonds and CDs, as well as to growth and income stocks that pay dividends. There is an appropriate place for both in a well-diversified portfolio.
Purchase municipal bonds
If you’re in one of the top tax brackets, you may benefit by investing in municipal bonds. When you own a “muni,” your interest payments will be free from federal income taxes and possibly state and local taxes as well. In fact, the tax advantage of municipal bonds may be so great that you’d have to earn a considerably higher interest rate on a taxable bond – such as a corporate bond – just to get the same after-tax return (keep in mind, however, that some municipal bonds may be subject to the alternative minimum tax).
“Max out” on your 401(k)
Contribute as much as you can afford to your 401(k). Your contributions are typically made with pre-tax dollars, so, the more you put in, the lower your taxable income will be. And your earnings grow tax-deferred.
Meet with your investment and tax professionals to discuss these and other ideas. But don’t wait too long – the quicker you put some of these suggestions to work, the better off you will be when April 15 rolls around again.
Steven E. Levitsky is Investment Representative, Edward Jones Investments of Acton (978-635-1525). This article is intended for informational purposes only. It is believed to be reliable, but its accuracy and completeness are not guaranteed.
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