President George W. Bush is back for round two. His 2001 tax cut, which was intended to shore up the sagging economy, put money in the pockets of taxpayers in the form of tax rebates. The Bush administration’s new stimulus plan offers another round of tax breaks, ranging from the reduction of rates and the abolition of the so-called “marriage penalty” to the expansion of write-offs for businesses and the exemption of taxes for investors who receive dividends from their stock portfolios.
Although the details have yet to be worked out and political wrangling continues between Republicans and Democrats, it’s important to stay on top of these current developments. By doing so, you’ll be in a better position to employ DOFE principle No. 5: to engage in sound budget, credit, and tax management practices. The following are a few highlights of the president’s proposal–and tips on how you can prepare for them:
REDUCED RATES MAY BE COMING–BUT TAKE ALL YOUR DEDUCTIONS NOW
The 2001 tax law calls for a scheduled reduction in income tax rates. Today’s 27% rate, for example, would drop to 25% in 2006 and the current top rate of 38.6% would fall to 35%. President Bush’s new tax plan would make the lowest rates effective in 2003, retroactive to Jan. 1. “Tax deductions are more valuable when tax brackets are higher,” says Ralph Grant, a partner in Oakland, California-based accounting firm Grant & Smith L.L.P. “If possible, you should maximize your deductions for 2002, when rates were higher than they might be this year. There is still time to make 2002 contributions to certain retirement plans.”
If you had self-employment income in 2002, for instance, set up a simplified employee pension (SEP) before you file your 2002 tax return, including extensions, and make deductible contributions. This is a strategy used by a number of self-employed professionals like Paul Washington, 33, an Oakland, California-based investment banker. “I’ve made that type
of after-the-fact contribution to my SEP in the past,” says Washington. “Now, though, I try to make my SEP contribution when I close transactions and collect a success fee.” For 2002, you can contribute about 20% of your self-employment income to your SEP, for a maximum contribution of $40,000.What about IRAs? These accounts can be set up by April 15, 2003, to make a 2002 contribution, but keep in mind that not all IRA contributions will be deductible. Taxpayers can deduct IRA contributions of up to $3,000 if they weren’t covered by an employer-sponsored retirement plan in 2002. Those individuals who were 50 years of age or older can add an extra $500. If you were covered by a plan, contributions will be fully deductible if your income was under $44,000 last year, or $64,000 on a joint return. For one-income couples in which the breadwinner is covered by an employer’s plan, the stay-at-home spouse can get a full IRA deduction if the family’s income was under $150,000.
GET A BREAK BY EQUIPPING YOUR BUSINESS
Current law permits small businesses to deduct $25,000 worth of equipment purchases in 2003 as opposed to depreciating the outlays over several years. The Bush plan would boost that allowance to $75,000–a proposal generally supported by Republicans and Democrats. “If you need the equipment, buy it,” says Grant. “However, don’t incur an obligation to purchase unnecessary equipment just to get a tax break.”
UNDERSTAND THE NEW RULES OF INVESTING
The new proposal would exempt dividends from personal income tax. That is, an investor could buy 100 shares of a company, collect a $25 quarterly dividend, and pay no tax on that income. “Such a proposal, if passed, would make dividend-paying stocks more attractive,” says Bill Wixon, a financial planner in Plymouth, Minnesota, and a member of the Financial Planning Association of Minnesota, a 900-member nonprofit organization. “The same is true for mutual funds that hold dividend-paying stocks. Nevertheless, I wouldn’t rush out to buy dividend-paying stocks or stock funds that you wouldn’t buy otherwise. Wait and see what legislation actually is passed.”
For now, Wixon cautions investors about putting money into municipal bonds or muni funds. “They’ll be hurt by this type of legislation,” he says. “Dividend-paying stocks may offer comparable yields, tax-free, as well as appreciation potential.”
But should you put dividend-paying stocks and stock funds inside a tax-deferred retirement plan, such as an IRA or a 401(k)? Since withdrawals from such plans are fully taxed, you might wind up converting tax-free dividends into taxable income.
If passed, the new tax laws may provide you with a bevy of breaks. However, as you engage in your tax planning, whether you’re a professional or an entrepreneur, seek out advice from top-flight accountants, tax attorneys, and financial planners. With the dawning of this new era of taxation, you need not, and should not, go it alone.