TRUE, the new tax law doesn't kill the levy on dividend income as some had hoped, but investors still have plenty to cheer about.
The law reduces the tax rates on capital gains and dividend income, and accelerates cuts in ordinary income tax brackets.
"It's huge. Any time you increase the after-tax return on investments, that has to help the value of the underlying investments," said Chuck Carlson, chief executive of Horizon Investment Services in Indiana.
"In some respects, this may be better than if they totally eliminated taxes on all dividends," he said. "Growth investors got something with a reduction of capital gains and dividend investors got something, too."
Specifically, the new law:
Cuts the tax rate on long-term capital gains, profits on investments held at least a year, from 20 percent to 15 percent for those in higher-income tax brackets.
"Not even President Bush was asking for that," said Mark Luscombe, a principal with CCH Inc., an Illinois tax-information company.
Those in the lowest brackets - 10 percent and 15 percent - will pay a rate of 5 percent through 2007 and zero in 2008.
The tax break is effective on gains realized after May 5 and expires in 2009.
Reduces the tax on dividend income for most investors to 15 percent, retroactive to January. Dividends had been taxed as ordinary income, up to 38.6 percent.
The rate for those in the two lowest brackets falls to 5 percent through 2007 and zero in 2008.
The tax break ends in 2009.
Speeds up the reductions in ordinary income tax brackets. Gone are the 27-, 30-, 35- and 38.6 percent brackets. Replacing them, retroactive to Jan. 1, are 25, 28, 33 and 35 percent.
But beware: In 2011, brackets revert to the levels before the 2001 tax cut: 15, 28, 31, 36 and 39.6 percent.
Of course, the desire to avoid taxes shouldn't override building a portfolio based on when you'll need the money and your risk tolerance. "Don't let the tax decision drive the investment decision," said Lyle Benson, president of L.K. Benson & Co. in Towson.
The many benefits of a 401(k), for example, still make it worthwhile to invest in the plan, even though all withdrawals are taxed as ordinary income and not at a lower capital gains rate, experts said.
Still, the new law offers some tax planning opportunities, such as shuffling investments between taxable and tax-deferred accounts to lessen the tax bite. Here are some strategies to consider:
Know where to hold 'em. Interest income and dividends from real estate investment trusts (REITs) remain taxed as regular income. For that reason, taxable bonds and REITs are best held in tax-sheltered accounts, such as a 401(k) or a traditional individual retirement account, where at least they'll get tax-deferred growth.
On the other hand, growth stocks and dividend-paying equities should be held in taxable accounts to take advantage of the lower dividend and capital gains tax rates.
Don't overlook the big picture. If you need interest income for living expenses, don't keep those investments in an IRA that carries a penalty for early withdrawals, said Clint Stretch, director of tax policy for Deloitte & Touche in Washington.
Avoid turnover. Now there's even more reason to avoid frequent trading. Short-term capital gains - profits on investments owned less than a year - remain taxed at the regular income tax rate, or as much as 35 percent.
It's not only their own trading that investors need to watch. "Funds that have a lot of turnover and a lot of active trading will generate short-term gains," Benson said. "You want to avoid the funds that do that."
The law makes index funds more attractive because of their minimal turnover, he said.
Investors who can't resist frequent trading should do so in tax-sheltered accounts, where short-term gains aren't an issue. Also, some mutual funds, such as small-cap funds, tend to have higher turnover and should be held in tax-deferred accounts, Benson said.
Seek growth and income. With long-term gains and dividends taxed the same, consider companies that offer both, Carlson said.
He predicts that cash-rich companies that already pay dividends will increase their payouts. "There will be pressure on them to do that instead of frittering that away on acquisitions or senseless growth [schemes]. Shareholders will say, `You know what, start paying it out to us,'" Carlson said.
Give stock. Parents may want to give appreciated shares to children who are at least 14, the age when they are no longer taxed at the parental rate, said Christine Fahlund, senior financial planner with T. Rowe Price Associates in Baltimore.
As long as children remain in the lower tax brackets, they will pay 5 percent tax on capital gains for the next few years and no tax in 2008, Fahlund said. This strategy is subject to gift tax rules, so two parents can give shares worth up to $22,000 a year to one child, without tax consequences, she said.
Tax breaks come and go, but experts predict some breaks will become permanent. Which ones depend on who sits in the White House, what party controls Congress, and the state of the economy and budget.
Meanwhile, that makes planning awkward - and interesting - said Bill Ross, tax director at Stegman & Co. in Baltimore.
"You don't have to rush to lock in the 15 percent capital gains right now," he said. "What happens when you get to 2008 and you just don't know what's going to happen? Do you turn around and sell some assets to lock in the lower rates? That's where it gets kind of exciting and interesting."
To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose- @baltsun.com.