Still Taking Advantage of the 0% Tax Rate

The 0% tax rate still is in effect. Created for select taxpayers for 2008-2010, it was extended with other tax breaks in the December 2010 tax deal in Washington.

The 0% tax rate applies to long-term capital gains and qualified corporate dividends earned by those in the two lowest income tax brackets. For other taxpayers those sources of income face a 15% maximum tax rate. For 2011, the 0% tax rate applies to single taxpayers with taxable incomes up to $34,500 and married couples with taxable incomes up to $69,000. Remember these are taxable incomes. You can qualify for the 0% tax bracket with higher gross income because you’ll have personal and dependent exemptions, itemized expense deductions or the standard deduction, and perhaps other tax breaks to reduce taxable income.

But higher-bracket taxpayers might be able to take advantage of the 0% bracket themselves or with some family tax planning. It is not an all-or-nothing situation. Because the tax rates are graduated, even some taxpayers with incomes above the threshold could have some income taxed at the 0% rate.

Here are some strategies for taking advantage of the 0% tax rate. See if any fit your situation.

– Remember that taxable income is what determines the 0% tax rate. Interest from tax-exempt bonds and distributions from Roth IRAs aren’t included in taxable income. So, to the extent that you can shift income to these two sources, you might qualify for the 0% tax rate.

– When you 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. 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 $39,000 of that capital gain is taxed at the 0% rate. The rest of the gain is taxed at the 15% rate.

– Bunching tax deductions (such as charitable contributions) into 2011 could reduce your taxable income enough that all or part of capital gains would be taxed at the 0% rate.

– Since qualified corporate dividends are taxed at 0% for those in the lowest tax brackets, you might find it advantageous to switch some of your portfolio into dividend-paying stocks.

– When you are supporting someone in a low tax bracket (whether it is a parent or an adult child), you could give some appreciated securities to them. They could sell the securities 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.

When you try to use this strategy with children, don’t forget the Kiddie Tax. To qualify for the 0% rate children must be over 21, or over 23 if they are full-time students. The restrictions can be avoided if the children do not qualify as dependents on someone else’s 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.

Remember 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.

There are a couple of different ways to decide which assets to sell to capture the 0% tax rate. You might have an asset with a substantial capital gain that you’d like to realize at the lowest tax cost. You could sell enough of that asset to qualify all of the gain taken for the 0% tax rate. Or you could give portions of the asset to loved ones who qualify for the 0% tax rate. Each sells enough to realize the gain at a 0% rate. That way the family maximizes the amount of the gain that is realized tax free.

The other approach is to decide you want to maximize the amount of cash raised at the 0% rate. Instead of selling one asset with a big long-term capital gain, you could sell several assets, each having a relatively small gain. That might free up the most cash at the lowest tax cost.

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

The 0% tax rate should be of most interest to someone who plans to sell the asset in the next few years, needs to reposition a portfolio, or wants to raise cash for a new investment opportunity or make a purchase.

RW July 2011