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The
Center for Financial, Legal & Tax Planning, Inc. |
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Advisories
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Capital Gains – Ending the Confusion on Introduction Business people and other sophisticated
investors know the often stated rule concerning capital gains tax rates. As a general, often-stated rule,
people in the lowest two ordinary income tax brackets pay 5% on capital
gains, while taxpayers in the upper ordinary income brackets pay 15%. What many people erroneously conclude
is that taxpayers in the lower two tax brackets pay 5% on capital gains
regardless of what the amount of their capital gains are. Unfortunately, this conclusion is not
true in all cases! Policy Capital gains tax rates were formulated
to encourage investment in stock, real property, and other appreciable
property. Logically, a lower tax
rate would encourage people to invest.
Not long ago, the capital gains rates were 20% and 10%. Currently, they are 15% for upper
bracket taxpayers and 5% for lower tax bracket payers. The 5% capital gains rate is necessary
or otherwise lower tax bracket investors would not receive any beneficial tax
rate and therefore would be discouraged from investing. Confusion The often stated rule is rife with
misinterpretation throughout the profession and business community. It is best illustrated through this
example: A taxpayer earns a taxable income of $59,400 from wages,
salary, and tips for the year 2005.
This places him in the lower tax brackets. In addition, he sells stock for a
capital gain of $3000. Most
practitioners at this point would conclude that the taxes on the $3000
capital gain are $150. This is incorrect.
Mechanics The application of the rule is simple,
as long as you understand it.
Capital gains will be taxed at 5% only to the extent wage and other
income combined with the capital gain of the taxpayer totals under the $59,400
tax bracket. The key is, CAPITAL
GAINS ARE INCLUDED IN THE COMPUTATION to determine at what rate they will be
taxed. The amount of the gain
bringing the combined taxable income over $59,400 is taxable at 15%. To Illustrate consider the following: A taxpayer earns $50,000 in wages, salary and
tips. The taxpayer also has large
holdings in investments. He then
cashes in his investment portfolio for a large capital gain of $250,000 to move
into a different, more accessible account and begin retirement (not an
uncommon scenario). In this case,
the first $9400 of taxable capital gains income will be taxed at 5%. The remaining $240,600 is taxed at
15%, not 5%, for a capital gains tax of $36,560. Had the taxpayer divided the
transaction over years of retirement, he would have paid 5%. Planning Considerations Knowing the mechanics of the capital gains tax
makes it possible and easier to plan effectively. Our advice when planning to take
capital gains is to follow these guidelines: 1)
Cash in
investments during lower income years.
Do not cash in or close all of your retirement accounts during the
year of retirement. Given you
will have ordinary income that year, it is advisable
to plan your tax strategy to take advantage of the lower rate. 2)
Cash in investments
over time to avoid the 15% bracket.
Additionally, in the years after you retire, cash in your investments
over time. It makes absolutely no
sense cashing in investment accounts and then paying inflated tax rates. This goes for ordinary income as well. 3)
Be careful of
the Alternative Minimum Tax. As
you convert your accounts, AMT becomes more of an issue. The AMT exemption is $58,000. As taxpayers move beyond this amount,
complicated formulas are used to see if the taxpayer will fall victim to the
AMT. Conclusion Given that capital gains rules are generally
misunderstood, it is advisable to acquaint yourself with the rules. By knowing and applying the
rules, not only will you save taxes now, but it will help you in future tax
planning as well. Remember that
capital gains have two rates which are used. Keeping both capital gains and
ordinary income down when appropriate will benefit you, the taxpayer. When planning retirement, disposition
of assets, and the like, keep capital gains tax mechanics in mind and call
The Center with any questions. (05-03) To receive the Advisory by e-mail,
please send your address to lacie@taxplanning.com |
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The Center for Financial, Legal and Tax Planning,
Inc. 4501 W. (618)
997-3436 Fax: (618) 997-8370 ©
Copyright 2005. All rights reserved. |
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