by George G. Jones and Mark A. Luscombe

The Jobs and Growth Tax Relief Reconciliation Act of 2003 seems to have gotten enough press coverage to educate most people on the basics. It appears as if most taxpayers understand a new tax law has passed Congress that is likely to give most of them a little more take-home pay due to rate reductions, lower taxes on dividends and capital gains, and maybe even a check this summer if they qualify for the child tax credit.

However, taxpayers may need a little help in figuring out what actions, if any, they need to undertake to take maximum advantage of the new tax law.

Overwithholding and over-payment of estimated taxes

The expansion of the 10 and 15 percent rate brackets and reduction in the marginal rates for the four highest tax brackets are retroactive to Jan. 1, 2003. The Internal Revenue Service has promulgated new withholding tables reflecting these new rates and rate brackets, but the tables are to be applied prospectively. Many employers will not get the new withholding put into place until July.

The result is that many taxpayers will have overwithholding for the first six months of the year. Should taxpayers just wait until filing their 2003 return and get a larger refund, or should they revise their W-4s to increase their withholding exemptions?

For many taxpayers, increasing withholding exemptions even by one exemption might be overdoing it. One withholding exemption is roughly equivalent to an additional $3,000 in deductible expenses for the year, or $840 in tax savings for someone in the new 28 percent tax bracket.

However, the tax that was overwithheld for the first six months of the year may well have been less than half of that amount. It is probably only for taxpayers with incomes approaching $100,000 or more per year that it might start to make sense to look at a possible increase in the withholding exemptions on a revised W-4 to compensate for the overwithholding for the first half of the year. Also, any taxpayer changing the W-4 to compensate for overwithholding will probably want to consider changing it back at the start of 2004.

The withholding situation might be further complicated by taxpayers who use extra withholding to cover regular dividend payments or other regular non-payroll income. Such practices might increase the amount of overwithholding that occurred earlier in the year and increase the benefit of adjusting withholding to reflect the lower dividend tax rates.

Taxpayers who utilize estimated taxes rather than increased withholding to pay tax on their dividend income are likely to have overpaid their estimated taxes due in April 2003. This would only apply to dividends and not capital gains since the capital gain rate reduction was not effective until after May 5, 2003. These taxpayers could adjust their estimated taxes for the rest of the year to compensate for the overpayment in the first installment in April.

Dividend income

Taxpayers are likely to have some difficulty determining whether distributions that they receive are really dividends, even if they are labeled dividends. Since, under prior law, dividends received by individuals were taxed at the same rate as other income, labels were sometimes used carelessly and distributions were labeled dividends that really were not.

Corporations, mutual funds, brokerage firms and other distributing entities are likely to clean up their labels in the near future.

In the meantime, however, taxpayers may, in many instances, have difficulties in determining what was really a dividend. Mutual funds typically put a dividend label on distributions from money market funds and bond funds. Corporations put a dividend label on preferred stock distributions when the preferred stock was really being treated by the corporation as debt, and an interest deduction was being claimed by the corporation with respect to those distributions. S Corporations and REITs often put a dividend label on their distributions even though they do not meet the Code Sec. 316 definition of dividends.

Eventually, over the course of the next several months, the reporting accompanying distributions and tax reporting on 1099s will be modified to reflect the new reality that knowing what is a dividend really matters. In the meantime, taxpayers may need a lot of help in trying to figure out whether what purports to be a dividend distribution qualifies for the new lower rates.

Some taxpayers may also be confused by the Bush administration proposals that involved allocating taxed but undistributed corporate earnings to increase shareholder basis. Those proposals did not make it into the new law, but the plus for taxpayers is that true corporate dividends get the benefit of the lower tax rates whether or not a corporate-level tax was paid with respect to those earnings.

Investment allocations

Taxpayers are probably starting to see a lot of discussion about investing in dividend-paying stocks in taxable accounts and investing in taxable bonds in regular IRA and 401(k) retirement accounts. There is also discussion about whether it still makes sense for some taxpayers to fully fund retirement accounts or to put part of the assets that they would have put into an IRA or 401(k) into a taxable account. The issues basically involve the following:

● access to the funds - free in a taxable account, penalty in a retirement account;

● Applicable tax rate - lower dividend and capital gain rates in a taxable account, ordinary income rates in a retirement account;

● up-front deduction - available in a regular IRA or 401(k), not available in a taxable account; and,

● Deferral of tax - available until required distributions start in a regular IRA or 401(k), only available in a taxable account for capital gains by using a buy-and-hold strategy that could eliminate the tax on the gain completely if held until death.

The danger for most taxpayers here may be over-reacting to the legislation. It probably does not make sense for most taxpayers to eliminate a well-thought-out investment diversification plan in the retirement account portfolio to shift everything to taxable bonds.

It also would usually not make sense to put everything in a taxable account into dividend-paying stocks. For one, it is not clear yet whether the new law will cause more companies to start paying dividends. Most important, however, the taxpayer’s focus must still be on long-term total return, of which the tax treatment is just one component.

Finally, the dividends rate is effective only through 2008, and such preferential treatment may not prove ultimately to be as permanent as that afforded capital gains.

Summary

There is much for taxpayers to like in the new tax law - but there is also a lot that can create confusion.

Tax practitioners will need to help their clients understand the interrelationships of some of the changes and how they fit into not only the short-term issues of how much tax is due in 2003 but also the long-term maximization of retirement, investment and estate planning assets.

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