The 2003 tax act reduced the top tax rate on most tock dividends and long-term capital gains to 15%. For taxpayers in the lowest federal income tax brackets (10% and 15%), the tax rate on dividends and long-term gains was put at 5%.

Moreover, low-bracket taxpayers were scheduled to pay 0% on dividends and long-term gains in 2008. After 2008, though, the bargain rates were to expire so dividends would be taxed as high as 35%, long-term gains up to 20%.

The tax law, enacted May 17, 2006, extends the low rates for another two years. As a result, qualified dividends and long-term gains will be taxed no higher than 15%, through 2010. This creates the opportunity for longer-range investment planning.

Three-year tax holiday

The two-year extension applies to the tax rates scheduled to go into effect in 2008. Therefore, the 0% rate for low-bracket taxpayers will be available in 2008, 2009, 2010.

In 2006, the two lowest federal income tax rates cover taxable income (not gross income) up to $30,650. By 2008, inflation adjustments will send that ceiling higher, probably to over $32,000. On joint returns, the upper limit is now $63,100 worth of taxable income and may be around $65,000 by 2008.

Therefore, many college students and young workers will be able to pay no tax on dividends and long-term capital gains during those three years. (Children under age 18 also will be able to use the 0% tax rate, but such use will be limited by the new kiddie tax rules, described on page 2.)

In addition, many retirees likely will meet the income requirements for tax-free dividends and long-term capital gains in 2008, 2009, and 2010. This year and next, you should begin investment planning to enable family members to take full advantage of this opportunity for tax-free investment income.