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Consumer Reports

How your investments will be affected by new tax cuts | (KRT) Now that President Bush's tax cuts are passed, let's set aside for the moment the weighty issues about fairness, the budget deficit and whether cuts of this type will really make the economy perk up as promised.

Instead, let's dwell on the most important matter: What's in it for us?

For investors, the key elements are the cuts in tax rates on capital gains, dividends and income.

Fortunately, there's no need for investors to do anything radical immediately - the new rules will last at least five years.

With lower tax rates, you can sell a profitable investment and keep more of the proceeds now than you could have a month ago. But this should be an investment decision; tax issues should always take a back seat.

The new rules will be most useful in deciding what to do with new investment money - helping you decide which holdings belong in what types of accounts, for instance.

Under the old rules, long-term capital gains - profits on investments held longer than a year - are taxed at a maximum rate of 20 percent, or 10 percent for people in the lowest income-tax bracket.

Under the new law, affecting profits on investments sold after May 5, the top rate will be slashed to 15 percent for most investors, while the 10 percent rate will fall to 5 percent immediately and to zero in 2008.

Taxes on short-term capital gains - for investments held less than a year - will continue to be levied, as they are now, at income-tax rates, but those rates will come down slightly.

Taxes on dividends will generally be the same as those on long-term capital gains - 15 percent for most investors, 5 percent falling to zero for the least affluent.

This is a big change, since dividends are currently taxed at income-tax rates as high as 38.6 percent.

Finally, most income tax rates, which apply to ordinary income, short-term capital gains and interest earnings, will be trimmed. The rates for different tax brackets will be 10, 15, 25, 28, 33 and 35 percent, compared to 10, 15, 27, 30, 35 and 38.6 percent under the old law.

Taken together, how do all these changes affect investing strategy?

_Stocks: Clearly, the reduced long-term capital gains and dividend rates make stocks more attractive than they were, since investors will keep more of what they make.

_Bonds: Taxable bonds become relatively less attractive, since interest they earn will continue to be taxed at the income tax rate, which for many investors will be double the rate paid on stock gains and dividends. (An investor who sells a bond for more than she paid for it will, however, pay less tax on that profit because of the cut in the long-term gains-tax rate.)

_Holding periods: The advantage of long-term gains will grow slightly because the difference between long- and short-term rates will grow slightly. So there will be even more benefit to holding an investment for at least a year before selling it. Why pay 25 percent to 35 percent tax on profits if waiting can cut the bite to 15 percent?

_Account types: Many investors will benefit from reorganizing their holdings as old guidelines about what accounts are best for which investments change.

Investors who want to buy dividend-paying stocks and mutual funds have long been advised to get them in their tax-deferred accounts, such as IRAs and 401(k)s, rather than in ordinary taxable accounts.

Under the old rules, dividends were taxed as income in both types of accounts. But in a taxable account, taxes had to be paid the year dividends were received. In a tax-deferred account, the tax could be postponed until withdrawals were made many years later, leaving more money in the account to compound.

Now the calculation is different, since dividends earned in taxable accounts will be taxed at lower rates than those earned in tax-deferred accounts, which will still be taxed as income.

Hence, dividend-paying investments may do better in taxable accounts.

_Interest earnings: Interest-paying investments, such as bonds, would still be best in tax-deferred accounts. Interest will be taxed at income tax rates in either type of account, just as it is now. But the bill can be postponed in the tax-deferred account - ideally until the investor is in a lower tax bracket in retirement.

_Appeal of dividends: When it comes to stocks and stock funds, there's been lots of discussion about whether the tax changes would make dividend-payers so much more attractive that demand would cause their prices to soar.

That might have happened if the president had achieved his initial goal of eliminating the dividend tax entirely. But the more modest tax cut passed on Friday will certainly reduce this effect, which may already be accounted for in stock prices today. Also, the unexpected cut in capital gains tax rates makes nondividend-paying stocks more attractive as well.

The fact is, the average stock in the Standard & Poor's 500 index pays a dividend of only 1.74 percent. Reducing the tax rate on that tiny dividend won't put much money in the typical investor's pocket, though certain stocks with big dividends may benefit more.

_Planning: The tax cuts don't make long-term planning any easier. The cuts in dividend and capital gains taxes, for instance, last for only five years. Then the old rates return - unless lawmakers first extend the cuts or make them permanent.

This is the same gimmickry used to make the 2001 tax-cut package look less expensive in the long run. Bush and his supporters hope all their cuts will become permanent, but who knows if they will? The prudent investor will assume they won't.

By summer, your take-home pay may grow a little as the new income tax rates take effect. Best plan to save that money.

The tax cuts will make the federal budget deficit larger, perhaps forcing Washington to cut spending in the future. What you make in tax savings today may be lost in Social Security benefits tomorrow.

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