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Recent articles by Jeff Schnepper: • Readers love refunds -- but they're wrong, 11/30/2004 • How the tax code rewards the soldier, 11/14/2004 • Protect your family with a partnership, 11/14/2004 More... |
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Thanks to the 2003 tax law, investors gained some big tax breaks on capital gains. Here's how to reduce the hit on your capital gains and other tax-wise investment strategies. By Jeff Schnepper You've invested, you've made some money on your investments, and now you want to cash in some of those investments or take advantage of better opportunities elsewhere. Perfectly good and reasonable motivations. Now, you have to start thinking about the taxes unless your investments are in tax-deferred vehicles like Individual Retirement Accounts or 401(k) accounts. Like it or not, when you sell investments out of a taxable account, Uncle Sam gets his share. The first key to smart investment tax planning is the recognition of the special status of long-term capital gains. Capital assets include stock, securities, real estate held for investment and most properties held for personal purposes. Long-term capital gains Long-term capital gains are the profits from the sale of capital assets (such as stock or other investments) that you held for more than one year. The net long-term capital gains (profits made after subtracting any capital losses) receive special treatment.
If you are in the 25% bracket or higher, the 2003 tax law says, the maximum tax rate that you pay on such gains is limited to 15%. In the 15% or 10% bracket, the gain is 5%. So use the capital gains and losses rules to your advantage. Both long-term and short-term capital losses are allowed to offset any capital gains on a dollar-for-dollar basis. The excess losses reduce your other (ordinary) income. The maximum you can deduct in any given year is $3,000, however. Any losses that exceed the $3,000 limit can then be "carried forward" into future years until you have fully written off the losses. For example, if I have a net capital loss of $30,000, and no capital gains, it would take me 10 years to fully deduct that loss ($3,000 x 10 = $30,000). In this situation, I should use those losses to my advantage and take as many capital gains as possible, up to the $30,000 limit. Those profits would essentially be tax-free (except, of course that you paid taxes on those monies to begin with, if you recall.) Municipal bonds Having a maximum marginal tax rate of 15% on net long-term capital gains is good; having a rate of zero is even better. Any interest earned on municipal bonds -- bonds issued by the state or any subdivision of the state -- is not taxable for federal income tax purposes. (Some special purpose municipals may be subject to the alternative minimum tax but that discussion is beyond the scope of this article.) Because these are tax-free bonds, they usually pay a lower rate of interest than taxable bonds. In comparing returns, you should always compare the after-tax returns. Whichever investment offers the higher return should be your first choice, in most cases. Dont forget to consider the impact of state taxation in computing final yield. For example, most states do not tax interest on municipal bonds issued within their own borders but may tax the interest on bonds issued by other states. Check with your states tax department on the rules. Savings bonds To help finance qualified higher education expenses, Congress created an incentive to purchase U.S. Savings Bonds. Under current law, interest that accrues on savings bonds does not have to be reported until the bonds are redeemed, unless you decide to report the increase in redemption value each year. For years after 1989, you can potentially exclude all or a portion of the interest that accrues on the bonds. If you redeemed your bonds in 2004 and your adjusted gross income exceeded $89,750 on a joint return or $59,850 on all other returns, there is a phase-out of the benefit. The phase-out eliminates all of the benefits for families with adjusted gross incomes of $119,750 or more, or $74,850 on others. In 2005, the phaseouts start at adjusted gross income of $91,850 for joint filers and $61,200 for all others. The phaseouts end when income exceeds $121,850 for joint filers and $76,200 for all others. A qualified U.S. Savings Bond is any bond issued after 1989 at a discount to an individual who has attained age 24. Note that you, as the older generation, must buy the bond. If you put the bond in the name of the child, you lose the exemption. Remember the government bases the tax rate on the income youre making at the time you redeem the bond, not your income now. If you expect to be making substantially more when you redeem the bond, that higher income might disqualify you. Social Security If you receive Social Security, be aware that part of your payments may be taxable, depending on your income. In determining how much of your Social Security will be taxed, the Internal Revenue Service considers not only your taxable income, but your tax-free income as well. By increasing your tax-free income, you may be subjecting more of your Social Security income to taxation. One way to potentially avoid or reduce this problem is to switch from tax-free income to tax-deferred income. With a tax-deferred annuity, youre not taxed on the income earned. That happens once you take the distribution from the annuity. The deferred income earned by the tax-deferred annuity does not count toward the determination of the amount of Social Security that will be taxed. Therefore, if you do not currently need the cash flow from the investment, a tax-deferred annuity should be considered as a way to potentially reduce your taxes on your Social Security receipts. | |||||||||||||||
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