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: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.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.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.