Table 2 Click here to enlarge imageTax rate on dividends cut
Under the new tax law, dividends will be taxed at a maximum rate of only 15 percent to most doctors, down from a maximum rate of 38.6 percent under present law. Moreover, those in the lowest tax bracket (e.g., children age 14 or older) will pay tax at a maximum rate of only 5 percent for tax years 2003 through 2007. The 5 percent maximum rate for low-bracket taxpayers drops to zero for 2008, meaning that dividends will be tax-free for that year!
Stock dividends paid by both publicly-traded companies, as well as closely-held firms (including dental practices), qualify for the favorable tax treatment. Subchapter S company dividends, if paid from prior profits accumulated while operating as a "C" corporation, qualify for this extremely favorable tax break, although the doctor's pass-through share of the practice profits do not. Dividends from money market and bond mutual funds and REITs also do not qualify.
* Strategy: "S" corporation doctors who previously operated as a "C" corporation should pay out a higher percentage of their profits as dividends to qualify for this 15 percent rate.
* Strategy: Borrowing to buy dividend paying stocks can pay off handsomely with dividends taxed at a 15 percent rate and the margin interest deductible against ordinary income, taxed at rates of up to 35 percent. However, the new law allows doctors to deduct margin interest only to the extent of net investment income (not counting dividends and long-term capital gains). So to benefit from this strategy, doctors must have interest income, short-term capital gains or money market or bond fund dividends to deduct the margin interest against.
Lower capital gains rates
While Congress did not raise the $3,000 annual limit on deductions of excess capital losses, it did reduce the rate on long-term capital gains received after May 6, 2003, to only 15 percent. Congress rejected the IRS' plea for a January 1, 2003, effective date; unfortunately, this will lead to a paperwork nightmare for doctors with 2003 capital gains. Doctors receiving installment-sale payments after May 5, 2003 (from practice, office building or other real estate sales) qualify for these lower tax rates, even though the actual sale occurred earlier.
Moreover, the maximum rate on long-term capital gains for taxpayers in the lowest (10 to 15 percent) income bracket (e.g., children age 14 or older) drops to only 5 percent for sales after May 5, 2003, until 2008, when the tax rate falls to zero! Thereafter, the rate springs back to 10 percent in 2009.
These changes further enhance our long-recommended strategies for funding children's educational costs with tax-deductible dollars. As a result of investment losses, many doctors' college funds are well below the amounts required to meet their children's educational needs.
* Strategy: Doctors with appreciated stocks, bonds, or real estate, who need additional funds for college, can transfer these assets to their adult children, or to a family limited partnership (FLP) or limited liability company (LLC) set up on the children's behalf. The appreciated stocks, bonds, or real estate then can be sold and the proceeds used for college, with the gain taxed to each child 14 or older at a maximum rate of just 5 percent!
Children age 14 or older with no other income can receive up to $28,400 in long-term capital gains and dividend income this year, and pay federal income taxes at a rate of only 5 percent! Moreover, the total tax of $1,420 ($28,400 x .05) can be reduced to zero for college-aged children, by using the educational tax credits.
* Strategy: Doctors should hold stocks, bonds, and real estate at least a year before selling. While long-term rates have dropped to a maximum of 15 percent, short-term gains from assets owned for less than a year continue to be taxed at rates as high as 35 percent.
* Strategy: The new law places a real premium on deciding which investments to hold in retirement (retirement plan and IRA) and taxable accounts. For best results, use the allocations shown in Table 3.
* Strategy: As a result of these lower tax rates, doctors should avoid deferral schemes funded with after-tax dollars, such as tax-deferred annuities. In addition to the higher fees and surrender charges, all amounts withdrawn from annuities are taxed at higher ordinary income tax rates (maximum rate of 35 percent). If the same assets were held personally, all capital gains and dividends would qualify for the 15 percent maximum rate.