(MONEY Magazine) – When Congress pushed through a $350 billion tax package in a mad dash before Memorial Day weekend, it signed off on the third largest tax cut in U.S. history and handed a big political win to President George W. Bush. Whether the administration's bet that the immediate boost to the ailing economy and stock market (just in time for the 2004 presidential election) will outweigh the long-term costs of rising annual federal budget deficits remains to be seen. For now, though, nearly all 131 million federal taxpayers will receive goodies such as accelerated marginal income tax-rate cuts and increased child-care credits. And the investor class will enjoy tax breaks on capital gains and dividends.

While the investor tax breaks represent less than half the plan's stated cost (the biggest windfall for most taxpayers will come from the accelerated marginal tax-rate cuts, which are retroactive to Jan. 1), they raise the most questions--and offer the most opportunities. Under the new rules, the long-term capital-gains tax rate is 15% instead of 20% for most investors. Meanwhile, dividends that meet certain qualifications are taxed at the same 15% rate rather than at ordinary income tax rates that had been as high as 38.6%.

All investors should take a fresh look at their portfolios and their tax planning techniques. "The law itself is straightforward, but the ramifications are going to be more complex," says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young. One example: The tax breaks for capital gains and dividends will expire (or "sunset" in Washington-speak) in 2009.

In the sections that follow, we'll look at the broad portfolio strategy issues raised by the tax changes; at particular investments and whether investors should be getting themselves worked up into a dividend frenzy; and at the details of the tax rules and issues that must be addressed in the future.

PORTFOLIO STRATEGY

Should you adjust your portfolio to take into account the tax changes? And if so, how? Let's start with the obvious. You don't want to twist your portfolio out of shape in an effort to save a few bucks on taxes. "There is nothing in the tax bill that requires an immediate response," notes financial planner Harold Evensky. "The biggest mistake is [to heed advice stating that] 'this is a great opportunity to do this, that and the other.' Those people are going to get burned."

Deloitte & Touche ran asset-allocation models for aggressive, moderate, conservative and risk-averse investors. The study concluded that investors would have to make little or no change to assimilate the new tax law. For example, a risk-averse investor might shift 1% of his assets from bonds to domestic stocks. "This thing is really on the margins," says Doug Rogers, chief investment officer at Deloitte & Touche Investment Advisors.

The point to remember here is that taxes are not the key to asset allocation; your goals and risk tolerance are. Whatever combination of stocks and bonds you wanted before the tax cut is still the one you should have now. For example, you might be tempted to swap taxable bonds paying 4% for a stock with a 4% yield to nab the tax break. But you'd be taking on more risk in the process. Bonds are usually a sure thing when held to maturity, but stocks in even seemingly safe, dividend-paying sectors like utilities can experience price drops. That may not be worth a few basis points in after-tax yield.

The new rules also reinforce another principle of sound investing: holding for the long term. That's because the spread between short-term gains (taxed at income tax rates, now as high as 35%) and long-term gains (taxed at 15%) is that much wider. The converse is also true: The tax cut magnifies the disadvantages of day-trading and other heavy-turnover methods.

RETHINKING RETIREMENT

The new rules do, however, change the dynamics of saving for retirement. For starters, they make tax-sheltered accounts like 401(k)s somewhat less compelling. There has always been a trade-off with such accounts: In exchange for having your investments grow tax deferred, you paid regular income tax rates on your withdrawals rather than the more favorable capital-gains rate. Now the gap between regular rates and those for dividends and capital gains will be even greater--at least until the next round of tax changes. (The new law will also make variable annuities and nondeductible IRAs even less attractive than they were before because they offer no pretax deferral and no tax breaks at withdrawal.)

Does that mean you should shift money from your 401(k) to your taxable account? Again, no. The main advantage of retirement accounts--tax deferral--continues to make them a good deal for investors. That's even more true for people who work for companies that offer matching contributions, which are essentially free money. So your strategy here too should remain the same as before: Sock away money in your 401(k) first (taking advantage of the match), next, if you're eligible, set up a Roth IRA (where you put in after-tax dollars and it grows tax-free forever), and only then invest in a taxable account.

Where you may want to change your strategy, though, is in determining which assets to hold in your taxable account and which belong in your tax-deferred accounts. Specifically, you'll want more equities in your taxable account (taking advantage of the lower rates on capital gains and dividends) and more taxable bonds in your tax-advantaged accounts (sheltering those payouts from tax until withdrawal). Tax-free muni bonds, of course, remain in the taxable account.

Before making any move, you will want to evaluate your entire portfolio. The key is the cost--in commissions and taxes--of making the changes. But if you have losses in your taxable account, now is a great time to upgrade your portfolio.

THE EFFECT ON EQUITIES

In the long term, the tax reductions will boost investors' returns and make stocks more attractive. In dollar terms, the big numbers will come from the dividend-tax cut (at a cost to the Treasury of $126 billion), not from the reduction in capital-gains taxes ($22 billion). As a result, everyone has focused on dividends. Indeed, on the day Congress passed the tax-cut legislation, utility stocks, which usually pay healthy dividends, rose 4%. But all that attention may be misplaced: It's true that dividends are far more attractive than before; however, that alone should not make you as an investor emphasize dividends over capital gains. In fact, tax experts say, for tax purposes you should still prefer capital gains--if you can get them--over dividends because you don't pay the capital-gains tax until you sell, while you must pay the dividend tax as soon as you receive the payout. "I wouldn't go out and automatically seek out dividend-paying stocks," says Joel Dickson, Vanguard's in-house tax expert. "They are now taxed at the same rate, but capital gains retain their preference because you can defer capital gains."

In a sense, the tax issue for dividends is a red herring, since it simply removes their disadvantage, and much of the stock gains that might accrue from that field-leveling have taken place in this spring's rally. The real issue going forward is whether dividend payers outperform over the long term--and what impact investors' newfound love of dividends will have in such an uncertain and volatile market. "Dividends are cash in hand, and you cannot manipulate cash like you can earnings," says Sheldon Lieberman, manager of Hotchkis & Wiley Large Cap Value fund, which is biased toward dividend payers. "Given the scandals of the past few years, there is extra appeal to dividends, with or without the tax cut."

If you do choose to buy dividend stocks, the strategy we have recommended in the past still holds: Stick with companies that have modest payout ratios (dividends per share equal to less than 50% of operating earnings per share) and relatively low debt loads (a debt-to-equity ratio of less than 50% is a cautious yardstick). Also look for companies that have plenty of cash or generate enough cash flow to expand the business or raise the dividend. Those criteria will help you find stocks with room for both share price and dividend growth. As Smith Barney's senior equity strategist Tobias Levkovich counsels, "Don't just chase yields."

One detail that shouldn't be overlooked: Not all dividends get the tax break. For technical reasons, the majority of preferred stocks and the bulk of dividends paid out by real estate investment trusts will not. Instead, these payouts will be taxed as ordinary income with the top rate now reaching 35%. But does that mean you should avoid REITs? Not necessarily. For one thing, with an average yield of 7.8%, REITs will still offer a compelling after-tax payout. And history shows that a dose of real estate stocks can add stability to your overall portfolio. Once again, a tax-law change alone shouldn't dictate your investment strategy.

IMPLICATIONS FOR FUNDS

For mutual fund investors, some dividends will qualify for the 15% rate, others will not. That's because mutual funds issue multiple types of payouts and dub them all dividends. Dividends paid by stocks in the fund and passed through to shareholders will qualify for the new tax rate. Other payouts, such as interest from bonds or various other capital distributions, will not. The Internal Revenue Service is now redesigning Form 1099 (which details dividends received for tax-reporting purposes) so that it indicates which dividends qualify for the new rate.

BEDEVILING DETAILS

Complications and unresolved issues? There are plenty. First, there's the problem of this year: The new tax rules for capital gains went into effect as of May 6, creating two different tax rates for one tax year. When investors match their capital gains and capital losses for the year, will they be required to match first-half gains with first-half losses and second with second? That's still to be determined. Then there's the required dividend holding period. Roughly, to receive the tax break, you must own the stock for at least 60 days around the "ex-dividend" date (the day on which the stock starts trading without its dividend). The rule works like the wash-sale rule: Sell too soon and your dividend won't qualify; you'll have to pay ordinary tax rates. To get the full benefits of the dividend-tax break, be prepared to do some careful timing before selling any shares. And don't be confused by the similar tax rates on dividends and capital gains: You still can't offset dividend income with capital losses. The IRS is rewriting Schedule D, and there are likely to be a lot of errors on this year's returns.

LOOMING BATTLES

One thing is sure: This won't be Washington's last go at the tax code. In just a few years, Congress will have to take up the same issues again because most of the bill's provisions are set to expire over the next few years. (For details on the sunset provisions, see the chart on page 36.) Depending on the economy, it could be a tough battle. Renewing the provisions would easily push the tax package's total cost to more than $800 billion over the next 10 years.

Just as significant may be the issue of the alternative minimum tax. This second tax system was aimed at a handful of ultrarich taxpayers with extensive deductions. But the threshold for paying the AMT was never indexed for inflation. What this means is that more than 2 million taxpayers are expected to pay the AMT this year, and more will follow.

The new tax package includes a patch--it increases the AMT exemption by $4,500 for singles and $9,000 for marrieds. But that will merely delay the impact of the rate cuts until 2005, when the patch expires. According to the Urban-Brookings Tax Policy Center, nearly 13 million taxpayers--including an increasing number of middle-income filers--are expected to be hit by the AMT in 2005. Ironically, lower federal rates (especially when combined with higher state taxes and increased deductions) mean that more taxpayers will be subject to the AMT.

"This is going to be the thing that gets people banging on the doors of Congress," says Gayllis Ward, head of Fiduciary Trust's tax division. "I think that is the coming battle."

ADDITIONAL REPORTING BY JONAH FREEDMAN, TARA KALWARSKI AND STEPHANIE D. SMITH