Taking Advantage of the 0% Tax Rate

There still is time to take advantage of the 0% tax rate. This special tax benefit was put in effect for select taxpayers in 2008, 2009, and 2010 for their long-term capital gains and qualified dividends. Even if you are a higher-bracket taxpayer, you may be able to benefit from the 0% rate.

The 0% rate is available to those in the 10% and 15% tax brackets. It applies to long-term capital gains and to qualified dividends, items that would qualify for the 15% maximum rate for taxpayers in the 25% and higher brackets. In 2009, single taxpayers with taxable income up to $33,950 and married couples filing jointly with taxable incomes up to $67,900 qualify for the 0% rate.

You can benefit from the 0% rate even if your taxable income is above these levels. A couple that normally has taxable income of $30,000 can realize a long-term capital gain of $70,000, bringing their taxable income to $100,000. The first $35,100 of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

You might be able to restructure your income or asset ownership to take advantage of the 0% rate for some assets.

– Interest from tax-exempt bonds and distributions from Roth IRAs are not included in gross income. Shifting some income assets to tax-exempt bonds or converting a traditional IRA to a Roth IRA could reduce income enough in 2010 to make you eligible for the 0% rate on long-term capital gains and dividends.

– Bunching tax deductions (such as charitable contributions) into either 2009 or 2010 could reduce your taxable income enough that all or part of capital gains would be taxed at the 0% rate.

– When you already are in one of the lower brackets, it could make sense to sell assets with gains to capture the 0% rate or to shift some investments to stocks that pay qualified dividends.

Consider some other ways to profit from the 0% rate.

If you are supporting parents in a low tax bracket, you could give some appreciated securities to them. They could sell and pay the 0% tax rate on gains. Keep in mind if the gift exceeds the $13,000 annual gift tax exclusion per person, you might owe gift taxes or use part of your lifetime gift tax exemption.

You also could give to children in lower tax brackets, but they must be adult children. Congress changed the law on the Kiddie Tax to prevent high income parents from giving securities to their minor children to sell and pay 0% rate. To qualify for the 0% rate children must be over 21, or over 23 if they are full-time students. The restrictions also can be avoided if the children do not qualify as dependents on their parents’ tax return. To do that they must provide more than 50% of their own support and earn income. Details are in free IRS Publication 17, Your Federal Income Tax. Other than those situations, the incomes of the youngsters must be less than $1,800 to qualify for the 0% rate.

 Couples receiving Social Security benefits will have to be careful when executing these strategies. Recognizing long-term capital gains will increase adjusted gross income and could make more Social Security benefits subject to income taxes. In most cases, the additional tax on the Social Security benefits will be quite low. Even so, you should run the numbers to determine the effect such a transaction would have on your full tax picture.

Don’t let the tax tail wage your financial dog. You need a reason to sell an asset other than to grab the 0% tax rate. The difference between the 0% rate and either the 5% or 15% rate is small in actual dollars, especially considering that only gains below the taxable income thresholds for the lowest brackets qualify for the 0% rate.

The 0% rate is advantageous to someone planning to sell the asset in the next few years, who needs to reposition a portfolio, or has a new opportunity and needs to raise cash.

Normally, with a tax-advantaged strategy you want to maximize the gains taxed at the low rate. You would sell the assets with the highest amount of gains. But there is a ceiling on the amount that qualifies for the 0% rate each year. Once you are pushed above the 15% tax bracket, the higher capital gains rate kicks in. You might want to maximize the amount of cash raised at the low rate. To do that, you might sell a number of assets, each having small gains. That might free up the most cash at the lowest tax cost. This is a good strategy for retirees who are deciding which assets to sell to pay for their expenses the next few years.

The 0% tax rate is tricky. But there are many retirees who qualify for it, and they should review asset sale strategies.

RW November 2009.