Let’s do
something a little different this time.
I want you
to see numbers the way a tax CPA does.
Let’s say
that you are semi-retired and you bring me your following tax information:
W-2 24,000
Interest
income 600
Qualified
dividend income 40,000
Long-term
capital gains 10,000
IRA 24,000
Looks to me like you have income of $98,600.
How about
deductions?
Real
estate taxes 10,000
Mortgage
interest 5,000
Donations 26,000
I am seeing $41,000, not including your exemptions.
You did some quick calculations and figure that your federal
taxes will be about $6,500. You want to do some tax planning anyway, so you set
up an appointment. What can you do to reduce your tax?
What do I see here?
I’ll give you a hint.
Long-term capital gains have a neat tax trick: the capital
gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower.
This does not mean that you cannot have a tax, mind you. To the extent that you
have taxable income in excess of those capital gains, you will have tax.
Let’s walk though this word salad.
Income $98,600 – deductions $41,000 – exemptions $8,100 =
$49,500 taxable income.
You have capital gains of $10,000.
Question: will you have to pay tax on the difference – the $39,500?
Answer: qualified dividends also have a neat tax trick: for
this purpose, they are taxed similarly to long-term capital gains.
NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.
You have capital gains and qualified dividends totaling
$50,000.
Your taxable income is $49,500.
All of your taxable income is qualified dividends and capital
gains, and you never left the 15% tax bracket.
What is your tax?
Zero.
How is that for tax planning, huh?
From a tax perspective, you hit a home run.
Let me change two of the numbers so we can better understand
this qualified dividend/capital gain/taxable income/15% tax bracket thing.
W-2 36,000
Qualified
dividends 28,000
As you probably can guess, I left your taxable income
untouched at $49,500, but I changed its composition.
You now have capital gains and qualified dividends of
$38,000. Your taxable income is $49,500, meaning that you have “other” income
in there. You are going to have to pay tax on that “other” income, as it does
not have that qualified dividend/capital gain trick.
The tax will be $1,153.
You still did great. It is just that no tax beats some tax any
day of the week.
It is something to consider when you think about
retirement planning. We are used to thinking about 401(k)s, deductible IRAs,
Roth IRAs, social security and so on, but let’s not leave out qualified
dividends and capital gains. Granted, capital gains are unpredictable and not a
good fit for reliable income, but dividend-paying stocks might work for you.
When was the last time Proctor & Gamble missed a dividend payment, for
example?
OK, I admit: if you leave the 15% tax bracket the above technique
fizzles. That however would take approximately $76,000 taxable income for
marrieds filing jointly. Congrats if that is you.
BTW I saw scenario one during tax season (I tweaked the
numbers somewhat for discussion, of course). The accountant was perplexed and
asked me to look at the return with him. The zero tax threw him.
Now he knows the dividend/capital gain thing, and so do you.
