By Pam Feely, CPA

On May 28, 2003, President Bush signed the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Favorable tax treatment of dividends and capital gains created by this act will affect the investment choices made by financial advisors and their clients. Selection of municipal bonds, corporate bonds or dividend paying stocks may now change.

JGTRRA significantly reduced the tax bill for consumers. Dividends received by individuals from certain domestic and foreign corporations will be taxed at either 5 percent or 15 percent, depending on the investor’s marginal tax rate for the years 2003 through 2008. (Dividends will not be taxed for investors in the 10 percent or 15 percent tax brackets in 2008.) All qualified dividends for 2003 will receive the lower rates.

While there was some discussion about eliminating the taxation on dividends before the act was passed, there was minimal discussion about capital gains. The final version of the act includes taxing income from capital gains at the dividend rate for sales after May 6, 2003. Interest income remains at the investor’s marginal rate. The new tax law incorporates the lower capital gains and dividend rates for the alternative minimum tax computation.

Over the next few years, we will see more interest in assets that generate dividends and capital gains.

Impact on investments
Prior to the passing of JGTRRA, municipal bonds provided both the federal government and state governments with tax-free income and a steady stream of income. After JGTRRA, dividend-paying stocks will compete with municipal bonds and corporate bonds for a bigger place in your client’s portfolio. With the passage of JGTRRA, municipal bonds may actually demand a higher rate from investors. Cash-strapped municipalities may not be able to continue to offer the bonds at the present returns.

Assume your client, John Able, has a $1,000 municipal bond with a 3.5 percent yield, a $1,000 corporate bond with a taxable yield of 4.89 percent and 1,000 shares of stock that pay an annual dividend of $.50 per share. Under JGTRRA, which investment will generate the most cash?

The answer to this question is that the investment that generates dividends and capital gains—either as distributions or when sold—will provide $58 more, as shown in Table 2.

On May 28, 2003, the Dow Jones Industrial Index was 8,793.12. On July 14, 2003, the index closed at 9,177.15. This represents a 4.4 percent increase in 47 days. During the same period, the Federal Reserve reduced interest rates to a 40-year low.

Lower taxes
In addition to the more attractive cash flow, stocks offer a reduced tax bill when sold at a gain. Jeff Warren, a financial consultant with AG Edwards in Lakewood, Colo., states: “Clients need to consider increasing their investment in stocks between the favorable tax treatment on dividends and capital gains and the decline in interest rates for municipal and corporate bonds.” Stocks also offer the upside potential of generating capital gains. Since 1997, the tax rate on capital gains has declined from a maximum of 28 percent to the new low of 5 percent in some income brackets.

The more the percentage dividends consist of taxable income, the greater the tax savings will be and therefore, the more cash the investor will receive. For example, a client receiving $35,000 in dividends will pay a maximum federal tax of $5,250, while a client receiving taxable interest of $35,000 will pay a maximum 35 percent federal tax of $12,250. This is a difference of $7,000.

There is some evidence that public companies are moving toward paying out more in dividends than they have in the recent past. This change will give advisors pause to look at privately held corporations paying out dividends in addition to the salaries they pay their officers because corporations and shareholders combined may now pay a smaller tax bill.

Over the next few years, we will see more interest in assets that generate dividends and capital gains as investors seek to increase cash, boost returns and lower taxes. Municipalities will have to pay higher interest rates. Corporations will find it harder to issue bonds, but may find it potentially easier to issue new shares of stock.

You and your clients will find that the increased cash from dividends and capital gains may shift the portfolio mix. After all, all of us want to pay lower taxes—and earn higher returns.

Pam Feely, CPA, of Golden, Colo., assists clients in evaluating varous types of investments. Contact her at Feely2201@aol.com.

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