During last year's presidential campaign, we heard a lot about the "carried interest" tax loophole that allows some wealthy private equity managers to pay low capital gains tax rates rather than higher ordinary income rates on much of their income. The purpose of this article is not to debate whether the treatment of "carried interest" is good or bad, but to point out that I believe that today's capital gains tax rules can also benefit lower income tax payers and, in fact, mean that investing in stocks can be one of the best ways for them to grow wealth tax free.
Yes, tax free. I know that may be hard to believe, but, under current law, taxpayers in the lowest two tax brackets (10% and 15%) pay no taxes on long-term capital gains or qualified dividends.
Here are my five tips for lower-income investors who want to take advantage of this hard-to-be-beat deal.
Be aware that the 0% rate applies only to long-term capital gains or those on capital assets held for more than a year. Short-term gains are taxed at ordinary income rates. Therefore, I would be very careful to keep track of purchase and sale dates on all assets to ensure that they meet the long-term test.
Many Taxpayers Qualify
The 15% rate applies to single tax payers with taxable income of up to $36,250 and joint filers with income of up to $72,500. Note that this is the rate that applies to taxable, not gross income, which is a very important distinction. Taxable income is after all deductions, so taxpayers with relatively high gross income may qualify for the 0% capital gains rate if they have enough deductions.
Taxpayers should be careful when estimating whether they qualify for the 0% rate to include their estimated long-term capital gains in the calculation, since these gains will boost taxable income for the purpose of determining the tax payer's tax bracket.
Can Get Complicated
Determining when the 0% capital gains rate applies can be tricky, at times, and not every taxpayer qualifies for it. For example, some young investors are excluded from taking advantage of this rate. Also, seniors who receive Social Security income should estimate their taxes with and without capital gains, since capital gains income could affect how much of their Social Security income is taxable. Also, only qualified dividends receive capital gains treatments as discussed in detail at http://www.irs.gov/publications/p550.
When in Doubt, Get Professional Help
Given the issues discussed above, as always, I recommend that taxpayers consult a tax professional as part of their tax planning process. Also, more information on capital gains taxes is available at http://www.irs.gov/uac/Newsroom/Ten-Facts-about-Capital-Gains-and-Losses.
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