Although April 15 seems like a long wayaway, it's never too early to start thinkingabout next year's taxes. Implementing thefollowing tactics before year-end may make a bigdifference in what you owe the IRS.
•Take advantage of reduced dividends rates.Because dividends are essentially taxed twice—firstas corporate earnings and then as investor income—there has long been talk about lifting the income taxon dividends. While complete elimination is not onthe horizon, Congress has reduced the income taxrate on most dividends until the end of 2008. Toqualify for the reduced rate, the dividend typicallymust be paid by a US corporation. Dividends paidby foreign corporations also qualify under certaincircumstances, including if the stock is readily tradedon an established US securities market. Preferredstock dividends also qualify for the reduced rate, butpreferred debt dividends do not.
•Rebalance your portfolio for tax efficiency.Because tax rates are currently 15% for qualifieddividends and long-term capital gains, it may notmake sense to hold certain investments in a tax-deferredaccount only to pay taxes later when takingwithdrawals. For example, dividend-paying stocksin a taxable account incur taxes at 15% wheneverthe company pays a dividend. Yet if you hold thatsame stock in a tax-deferred account, such as anIRA, you can be taxed at a significantly higher rate,as high as 35%.
•Think about bond swaps. Although bondsoffer stable income, their market value fluctuates asinterest rates rise and fall. As the Federal Reserveincreases interest rates, you should anticipate lowerbond prices down the road. Bond swapping is ayear-end maneuver used to realize a capital loss byselling bonds that have fallen in value and reinvestingthe proceeds in other bonds. When interest ratesincrease, it's possible to reduce taxes by recognizinglosses and increase income by reinvesting in higheryielding bonds.
Although this strategy can be effective in reducingfederal taxes, it is subject to the wash sale rule. Toavoid a wash sale, you should reinvest proceeds in abond with a different issuer. If the bond is from thesame issuer, be sure that the maturity date andcoupon rate are different.
•Remember to use prior year losses. In additionto using losses to offset gains, you can also useup to $3000 in net capital losses to reduce ordinaryincome in a single year. After the offset, you can thencarry forward any further capital losses to offsetcapital gains or ordinary income in subsequentyears. So if you still have capital losses lingeringfrom the bear market years in your stock portfolio,you may still be able to use them to offset gains orincome on your upcoming taxes.
Your financial consultant and tax advisor canhelp you determine what the best strategies are foryour specific situation and how you can plan aheadfor tax time.
Joseph F. Lagowski is vice president, investments, and a financialconsultant with AG Edwards in Hillsborough, NJ. He welcomesquestions or comments at 800-288-0901, or visit www.agedwards.com. This article was provided by AG Edwards & Sons, Inc,member SIPC.