By: Richard Feldman, MBA, CFP®, AIF®
The extension of the Bush tax cuts through December 31st 2011 provides two more years where individuals in the 10% and 15% tax bracket could pay nothing on capital gains and qualified dividends received. This means that a lot of individuals particularly retired workers could possibly pay no tax on capital gains or qualified dividends.
Capital Gains and Qualified Dividends
Qualified capital gains and dividends were taxed at a maximum rate of 15% (zero percent for taxpayers in the 10 and 15 percent brackets) for 2010. The 2010 tax relief act signed into law by President Obama continues this treatment for two years, through December 31st 2012.
In order to see who qualifies for the 10% and 15% tax brackets please see the 2011 IRS Federal Tax Brackets:
Personal Exemption: Will be $3,700;
Standard Deduction: The standard deduction for married couples filing jointly will be $11,600 and for single filers will remain at $5,800;
Annual Gift Tax Exclusion Amounts: For 2011 the exclusion will remain at $13,000;
Traditional and Roth IRA Contribution Limits: The Standard IRA contribution limit for 2011 will be $5,000 if you are under 50 and $6,000 if you are over 50.
Capital gains treatment typically applies to investments held for more than 12 months. The 15% capital gains rate is 20% less than the highest ordinary income tax rate which is 35%.
Qualified Dividend Income
Qualified dividends are dividends received from a domestic corporation or a qualified foreign corporation, on which the underlying stock is held for at least 61 days within a specified 121 day period. A qualified foreign corporation is eligible for U.S. treaty benefits or has stock that is readily tradable on an established U.S. securities market.
To the extent that capital gains and dividends, when added to other sources of income, do not exceed the 15% income tax threshold (please see 2011 Federal Income Tax Brackets on first page) are tax free and receive a 0% tax rate.
For example: Lets say that you are married filing jointly, you have three kids, and that you take the standard deduction and do not itemize. You could have $99,100 of taxable income and still be in the 15% bracket. The math is the following:
Taxable Income: $99,100
Personal Exemption: $18,500 (5 X $3,700)
Standard Deduction: $11,600 (Standard Deduction)
Taxable Income $69,000
As you can see you can earn significant amount of income and still be in the 15% bracket. If you itemize you could theoretically have even higher income and still end up in the 15% tax bracket which would mean no taxes on long term capital gains and qualified dividend income.
There are significant planning opportunities for individuals that have appreciated stock or mutual funds that are held in taxable accounts and are in the 10% or 15% tax bracket. One strategy would be to realize a certain amount of capital gains on your appreciated assets in either of the 2011 or 2012 tax years (Or Both Years) and still make sure you are in the two lowest brackets so that you pay no tax on the sales. You could then use the funds for living expenses or you could buy back the investments right away and reset your tax base therefore limiting your future capital gains tax exposure. In addition you could look at some location strategies by moving some dividend paying assets into your taxable accounts and moving some interest bearing assets into your tax deferred accounts. Interest income from fixed income investments would be taxed at your marginal tax bracket which could be 10% or 15% while qualified dividends would be tax free.
Please consult your tax advisor on your individual situation before making any changes in your investments and portfolio. This article is not intended to constitute tax advice.