Last month we looked at the implications of The Jobs and Growth Tax Relief Reconciliation Act of 2003 on portfolio planning and the focus on dividend-paying stocks. This month we’ll take a look at some of the issues as they relate to retirement investments and some of the complications and tricky issues that effect eligibility for tax breaks. The tax cut may sound straightforward but the ramifications for individual investors are more complex—especially because of the “sunset” provisions that may make the breaks vanish in a few years unless Congress takes further action. Again, in order to make the most of the tax breaks, investors should review the new rules carefully and get advice from their tax professionals and investment advisors now before making major changes to their investment strategy.

Should I shift money from my 401(k) to my taxable account to maximize my tax savings?
Although it is true that the new breaks make tax-deferred accounts-- including 401(k) plans-- less compelling, they remain a sound deal for many investors. And they might be for you, especially if you work for a company that matches your contributions—essentially giving you free money. Remember too, that these accounts give you upfront deductions and total deferral until the time you are required to start distributions. On the other side of the equation, you can also defer capital gains taxes in regular accounts if you buy and hold. Regular accounts also offer some flexibility and you will not be penalized for early withdrawal as you would in the tax-deferred accounts.

However, if you have both regular and tax-deferred accounts, you may want more equities in your taxable accounts (to take advantage of lower rates on capital gains and dividends) and more interest-bearing investment like taxable bonds in your tax-deferred accounts (to shelter them from tax until withdrawal).

If you have losses in your taxable accounts, now is the time to review your portfolio strategy. But, be sure to evaluate your entire portfolio with help from both your tax and your investment advisors before you make any major changes.

How do I make sure I reap the benefit from the cut in long-term capital-gains tax?
The long-term capital-gains tax cut lowered rates from 20 percent to 15 percent for those in the highest bracket and to 5 percent if you are in the 10 to 15 percent bracket. However, there are plenty of complicated issues here. The new rules went into effect on May 6 giving us two different tax rates for one year. It is still to be determined how investors are supposed to match up capital gains and capital losses for the year. Will investors be required to match gains made in the first half of the year with losses made in the first half, and, similarly, to match gains made in the second-half of the year with second-half losses? This has yet to be clarified. Also, don’t let the similar tax rates on dividends and capital gains confuse you. You cannot offset dividend income with capital losses—that has not changed.

Which dividends don’t qualify for the tax break?
The new rate cut applies to qualified dividends from corporations only. As we discussed last month, some so-called “dividends” are not really considered dividends at all under the new law. Interest income, short-term capital gains and other forms of income from mutual funds and from payouts from credit union savings are considered ordinary income and will be taxed accordingly. Bear in mind, too, that most preferred stocks and the majority of dividends paid out by real estate investment trusts will not qualify for the tax break.

The new law gives investors a lot to consider. Overall, stock market experts caution against emphasizing dividends over capital gains. The real issue going forward is whether dividend-paying stocks outperform over the long term, and whether investors shaken by the scandals of the past couple of years opt for the tangible benefits of cash in hand. As we end a quarter of bright performance that defied many traditional stock market truisms, the tax cuts give us more new factors to ponder as we look forward to the second half of the year.