A Significant Tax Break From the New Tax Act

Dear Readers,
Just in time for July Fourth, here's an idea that can provide you with some tax independence !

The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) signed into law recently offers a window of opportunity for those able to take advantage of it. I've covered the provisions of this legislation in previous articles ("President signs Major Tax Cut...Now What? " and "More on New, Lower Tax Rates for Stock Dividends.").

The strategy I'm going to outline here takes advantage of two changes made by this Act: the reduced tax rate on stock dividends and the cut in the capital gains tax. Both are in effect through 2008.

While the maximum tax rate on both stock dividends and long-term capital gains is now 15 percent, there hasn't been a lot of attention paid to the fact that both of these rates fall to 5 percent for folks whose adjusted gross income puts them into the 10-percent or 15-percent brackets. This includes children. So, if you give your child stock that pays dividends, provided her income -- including the dividends -- does not exceed $28,400, she will only have to pay 5 percent tax on those dividends. And if your child sells this stock, she will only pay 5 percent tax on the capital gains through 2006.

To see if someone you know qualifies, here are the income limits for the two lowest tax brackets this year:

Taxable Income
  Single Married, filing jointly
10% Tax Bracket: Up to $7,000 Up to $14,000
15% tax bracket: Up to $28,400 Up to $56,800

Now here's where it gets interesting: in 2008 -- and for this year only -- both the dividends tax and the capital gains tax drop to zero for folks in the two lowest income tax brackets. In other words, your child would pay NO tax on stock dividends received that year. If she sells the stock during 2008, all of the gain escapes federal tax !

While the reduced rate on stock dividends is sweet, the tax savings on any potential long-term capital gains could be enormous.

Let me illustrate: Suppose you're sitting on stock that has seen significant appreciation over the years. Perhaps it's a stock mutual fund that is worth $33,000 -- $10,000 more than when you made the investment 3 years ago. If you sell your shares to take your profit, unless you fall into one of the lower income tax brackets, you will pay a maximum of 15 percent on the gain, or $1,500.

On the other hand, you could divide your stock fund among your three children, gifting each $11,000 worth. Since this, amount does not exceed the annual gifting limit of $11,000 per person, you would owe no gift tax on this. Through 2008, the stock dividends received by your children are taxed at the lowest rate of 5 percent. If your children liquidate their investments before 2008, they will pay only 5 percent in capital gains tax.

Instead of $1,500 in capital gains tax, they'd owe a combined tax of $500 -- a $1,000 savings. And if they hold the stock into 2008, providing they meet the income guidelines, they would pay no taxes on either stock dividends or any long-term gains generated by the investment.

Using this same strategy, you can magnify the tax savings by gifting appreciated assets to your children over the next six years.

For instance, suppose you made an investment 10 years ago for $40,000. Today it's worth $132,000. If you and your spouse sell it, you will pay $13,800 in capital gains tax (15 percent x $92,000). Instead, the two of you use your combined gifting limit to give a total of $22,000 worth of this asset to your son. As a single taxpayer who falls into one of the two lowest brackets, when he sells the asset this year, the capital gains tax would only be $770 (5 percent x $15,400).

In 2004, 2005, 2006 and 2007 you gift another $22,000 worth of this investment to your son. Each year he sells it and pays $770 in capital gains tax.

Then we come to 2008. When your son sells the $22,000 in assets you give him in 2008, the long-term capital gains tax rate for his income bracket is 0 percent. He will pay no federal tax on the sale.

Instead of the $13,800 you and your spouse would have paid in capital gains taxes, your child has paid a combined total of $3,850 -- a savings of $9,950!

A word of caution: for this strategy to work, your child has to be at least 14 years old. If he is 13 or younger, then he will be subject to the same tax rates as his parents. If the child is under the age of majority in your state (usually 18 or 21), then the asset would have to be transferred to a minor's trust because it cannot be directly owned by the child. This approach still works because the trust pays tax based on the minor's rate.

One more thing. There's a narrow window of opportunity to take advantage of this strategy. In 2009 the tax rates on both dividends and capital gains revert to their 2002 levels.

Also, I'm assuming that you are considering this strategy only for assets that you and your financial advisor have agreed it makes sense to sell. You don't want to liquidate a winning portfolio solely for tax purposes.

Sonia King, assistant editor at the financial services publisher National Underwriter confirms this strategy. "The only downside is not financial -- it's personal," she says. "Once you gift the asset to your child, you lose control over it."

The other potential pitfall is Congress can always change the tax law and close this loophole. This will probably depend upon which party wins control over the House and Senate -- and White House -- in 2004.

Nevertheless, consider what this accomplishes:

- By transferring assets to your children, you significantly reduce or eliminate any tax on the gain.

- If the asset is stock issued by a C-corporation, you reduce the tax on the dividends, since these qualify for the lower 5-percent rate.

- You remove the appreciated asset from your estate for estate tax purposes. (Grandma, are you listening?)

As broadcaster and entertainer Arthur Godfrey once said, "I'm proud to be paying taxes in the United States. The thing is, I could be just as proud for half the money."

Here's to life, liberty, and the pursuit of lower taxes!



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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.