Just when you think the tax code couldn’t get more complicated, we approach 2010, when a multitude of taxes are waived and taxpayers are given large breaks (e.g. estate taxes repealed in 2010). There is one newer tax provision, however, that I have not heard discussed much at all is very lucrative for middle income investors. For the years 2008, 2009, and 2010, as the tax law stands now, the tax rate on qualified dividends and long-term capital gains will be 0% for taxpayers in the 10% & 15% Federal income tax brackets.
How come no one is talking about this? Granted those of us in lower tax brackets have had a 5% favorable rate for the past few years, so this is not a huge tax savings. But all the same, 0% sounds a lot nicer than 5%.
I think the reason this has gotten little press is that for the most part it is assumed that people in such low tax brackets don’t actually invest outside of their tax-deferred retirement plans. The point is well taken, but on the flip side, there are many retirees on fixed incomes who live primarily off investments, who have three years to do some wonderful tax planning. Also if you live in a high cost area, there are larger mortgage write-offs (and for those living in California, large state tax write-offs) which basically means most people living in the more expensive coastal areas can have fairly large incomes and still be in the lower tax brackets. This is also a great planning opportunity for money in your children’s name as children with investments are generally in the lowest tax brackets.
First, let’s discuss how this tax law works. One type of income that is subject to 0% tax in 2008 is qualified dividend income. In general, dividends are qualified if they come from domestic activities of corporations. As a general rule, foreign dividends won’t qualify, but domestic dividends do. It gets more complicated, but in general this will help you sort out what constitutes a qualified dividend. You can also look at prior tax statements (1099s) to get an idea how much of your dividends are qualified (each security should have a break out of total dividends and qualified dividends – on your 1099s and/or year-end statements).
Long-term capital gains are also subject to the 0% tax in 2008. A long-term capital gain is generated from the sale of a capital asset that you have held longer than one year. The most common examples would be stock or mutual funds that you have held for longer than a year.
Property like rental real estate could qualify for this 0% tax, but a portion of rental real estate is taxed at different rates for depreciation recapture, so it would be virtually impossible to sell rental property without any tax. Most importantly, even if you are in a lower tax bracket, the gain will most likely push you into a higher tax bracket. I wouldn’t tackle a tax strategy so complicated, when it comes to real estate without speaking with a CPA.
Of course, this does bring up the most important point. When planning to sell securities for the 0% gain, the most important thing to keep in mind is that any gains will increase your taxable income, and quite possibly increase your tax bracket, making these potential tax-free investments null and void. Just remember that you have to be in the lower tax brackets to take advantage, which makes it impossible to shelter large gains here from tax.
Here are some of the tax planning strategies you can employ:
1. Gift appreciated securities to your children. When you gift financial securities, the cost basis transfers to your child (cost basis generally being the price you paid for the securities). If you gift your child by directly transferring securities, they can then turn around and sell them for the same gain you would have reported, but they may get the benefit of paying 0% tax. Of course this is greatly complicated by kiddie tax rules which basically means only the first $1,700 in investment gains will be tax free, and everything above that reverts to the parent’s tax rate. The best strategy here is to perhaps gift stock with a $4,500 gain or so, and then sell 1/3 each year. This would be the best way to shelter the gain from taxes, but keep in mind dividends and other investment income the child might have.
2. For retirees on fixed income, they may want to sell some securities they have been wary of selling due to large gains and taxes. I wouldn’t necessarily be selling assets just for the tax-free status, but for investment sales you have been holding off due to tax ramifications, now is the time to take advantage. Spreading them out over three years is your best bet, as too much in one year can push you into higher tax brackets.
3. One strategy that I would be careful about, but so far seems fair, is to sell some appreciated securities, realize the gain, and immediately buy back the securities. Therefore you keep your investments as is, but you can increase your cost basis in them while limiting taxes. For now the tax code has “wash sale” rules which prevent you from selling stocks or funds at a loss for tax benefit, and then immediately buying back the same securities, but so far there is no same limit to selling stocks at a gain. I would be cautious with this as I would not be surprised if the law were eventually changed for this specific case. The fact is the IRS does not want you selling securities for tax gain and simply buying them back, any more than they want you to do the same for reporting losses, so I would keep up on the tax rules and make sure this is still the case once 2008 hits. In the end this may turn out to be a nice tax loophole.
As you can see, keeping up on all the tax thresholds, rules, kiddie taxes, tax brackets, etc. can be quite mind boggling. However, you have some time to evaluate your investments and come up with a plan. This may even be a time that warrants a visit to a CPA for a plan tailored to your situation, but probably only if you have large amounts of investments in taxable accounts. If most of your investments are in tax-deferred accounts like retirement, there is probably little you can do to take advantage here.
I know for me personally we have been toying with the idea of putting a little money in taxable investments, and now seems like a good time to do so, as well as setting up accounts for the kids, since we will face no income taxes on any investment gains most likely for the next three years. However I wouldn’t necessarily consider this until our ROTHs were fully funded (which to-date promise tax free investment gains for life and if nothing else, most certainly through 2010). This won’t be of monumental tax savings, but all the same, it makes investing in taxable accounts a lot more lucrative in the interim.