Year End Tax Planning
Recently I was doing some end of year tax planning to check that I have sent in enough estimated tax payments to the appropriate taxing authorities. In going through this analysis I take advantage of a little known recent tax law change. Since we are nearing the end of the 2011 tax year, I thought I would write about this tax law change in case there are other people who may be able to benefit from it.
The reason this tax break is not well known is because it is difficult to take advantage of it while you are still working. However it is a boon for younger retirees. What I mean by younger retirees are people who are retired but are not yet receiving social security benefits and/or withdrawing from their tax deferred retirement accounts. This change in the tax law concerns the Long Term Capital Gains (LTCGs) rate on the 10% and 15% tax brackets.
On May 17, 2006 President Bush signed the Tax Reconciliation Act which extended the 15% LTCGs tax rates in the higher tax brackets from 2008 to 2010. What many people are not aware of is that the 2006 Tax Reconciliation Act contained a clause that changed the LTCGs rate, starting in 2008, to 0% for the bottom two tax brackets.
That’s right; any LTCGs up to the top of the 15% tax bracket are now taxed at 0%. This special tax rate (along with all the Bush tax law changes) was scheduled to expire at the end of 2010, but when President Obama extended the current tax law until 2012, this part of the law was also extended. The table below summarizes the previous, current, and for now the future tax rates by tax bracket.
The 2006 tax law included another change for lower bracket tax payers. Starting in 2008, the 0% tax rate also applies to all qualifying stock dividends. (Note: these special tax rates do not apply at the state level).
The tax payer best suited to take maximum advantage of the 0% LTCGs and dividend tax rate is:
- A married couple who has income totaling less than $69,000 AGI in 2011 ($34,500 AGI if you are a single tax filer);
- Who is not yet receiving social security benefits or an employer provided pension;
- Who is not yet withdrawing money from any of their tax deferred retirement accounts;
- Who owns stocks with LTCGs (i.e., stocks held longer than 12 months).
It just so happens that my wife and I are one of these tax payers. The reason I was analyzing my tax situation so closely is because I was trying to determine how much stock I can sell at a profit and pay the 0% tax rate. There are a lot of things involved in our tax returns, but the bottom line is we are able to sell stocks that provide a total of $28,000 in LTCGs to go along with the $7,000 in qualified dividend income we have already received this year. This $35,000 income total will be taxed at 0% in 2011.
If you want to estimate your 2011 taxes, H&R Block has a simple online calculator. Click here to go the H&R Block page.
In our case we do not need the $28,000 capitals gains income to live on, but we are selling the appropriate stocks and creating the gain anyway so we can take full advantage of the 0% tax rate in 2011. These rates are only good through 2012 and will not likely be extended after that time so we want to take advantage of them while we can.
What if your gains are in quality stocks that you do not want to sell? That is our situation. However, this is not a problem as I will buy back the same stocks at the same price the same day. When you sell stocks at a gain there are no time rules limiting when you can buy back the same stock. All I am really doing is getting a tax free increase in our stocks’ cost basis.
As I was analyzing my tax situation for 2011 and realized how little federal income tax I will owe, it really dawned on me how valuable it is to have assets outside any tax deferred retirement accounts. You will learn more about the “Deferral Trap” in a later post.
In my next blog post I will provide an example, using the above tax breaks combined with a couple others, to show how a retiree can have $100,000 in spendable income and pay zero federal income taxes. It is not necessary to use highly paid accountants or employ any sophisticated tax avoidance vehicles. In fact you can do this using the “standard deduction” on your IRS Form 1040.
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