The Bogleheads' Guide to Retirement Planning (8 page)

For dividends to be qualified, the investor
must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date,
per IRS Publication 550. There is a caveat. If you have a stock mutual fund that pays dividends, the holding period refers to the fund’s holding period rather than to your holding period. Form 1099-DIV will list both ordinary dividends and qualified dividends from mutual funds.

When it comes to mutual funds, capital gains and dividend distributions are paid to you or credited to your account and are reported in box 2a of the Form 1099-DIV that you receive. The key point on these reported capital gain distributions is that you report them as long-term capital gains, regardless of how long you owned your shares in the mutual fund. Thus, before buying a mutual fund, you should inquire as to the date of the fund’s capital gain and dividend distribution and the estimated distribution to avoid “buying the distribution.” This is easily done by making your purchase after the distribution date rather than just before it. Buying the dividend is not a concern in a tax-advantaged account.

Capital gains occur when you sell an investment at a gain. The amount you pay in capital gains tax depends on how long you held the investment and what the investment is. Short-term capital gains are taxed as ordinary income, but long-term capital gains are taxed at a different scale than marginal rates, although it is a progressive scale. Long-term capital gains from stocks, bonds, and mutual funds are taxed at a lower rate than gains from selling certain property, gold, jewelry, art, and other collectibles.

To fully understand how your long-term capital gains are taxed, use the Schedule D worksheet that is part of your tax preparation booklet. The worksheet shows what amounts are taxed at the various rates and how capital gains interact with your ordinary income tax rate.

When you sell any asset, you realize a capital gain or loss. Each transaction will be classified as either short-term or long-term, and sometimes a combination of both. Short-term gains and losses are taxed based on ordinary income tax rates.
Short-term
is defined as a holding period of one year or less.
Long-term
is defined as a holding period of more than one year. For stocks and bonds, the tax rate is 5 percent or 15 percent (if your marginal tax bracket is 25 percent or higher). Thus, long-term capital gains on financial assets are taxed at more favorable rates than ordinary income tax rates. However, certain long-term capital gains are taxed at the 28 percent rate, such as the sale of coins, jewelry, and metals.

A capital loss may be deductible from capital gains if an investment was sold below its basis. Fundamental to realizing a capital gain or loss is the concept of basis. The basis of property is its cost. For stocks and bonds, the basis is generally the purchase price plus any costs of purchase such as commissions. If you buy the same stock or mutual fund at various times and then sell the entire lot, your basis will be your average cost. If you only sell a portion of an investment, then you may want to assign a basis to each tax lot. There are a number of ways to calculate your basis. These are covered in the IRS Publication 550 (see Stocks and Bonds under Basis of Investment Property).

Be aware that you cannot deduct losses from sales or trades of stock or securities if you create a wash sale. A wash sale occurs when you sell or trade stock or securities at a loss and, within 30 days before or after the sale, you buy substantially identical stock or securities. If your loss is disallowed because of the wash sale rule, add the disallowed loss to the cost of the new stock or security. This adjusts the basis in the new stock or security.

To compute your taxes with respect to capital gains and losses, you first combine all short-term capital gains and losses to figure your net short-term capital gain or loss. You then combine your long-term capital gains and losses to figure your net long-term capital gain or loss. You then combine your net short-term gain or loss with your net long-term capital gain or loss to determine if you can claim a capital loss deduction or if you will have a net capital gain that is taxed at a lower rate than other income. For a net capital loss, the IRS limits the amount of the loss for any one taxable year to a maximum of $3,000 ($1,500 if you are married and file a separate return). You can use your total net loss to reduce your income dollar for dollar, up to the $3,000 limit.

If your total net loss is more than $3,000, you can carry over the unused portion to the next year. The loss can be used to offset gains in the future or to offset $3,000 in ordinary income. Losses carry forward until the entire capital loss is completely used or the taxpayer dies. Only a surviving spouse can use capital loss carryover. It cannot be inherited by anyone else.

Taxes may be owed when you sell a home. This section discusses the tax implications of selling your primary residence, which is the main home you live in for more than two years.

The gain or loss on the sale of your main home is the selling price less the adjusted basis. Determine the adjusted basis by adding the price you paid for the home plus any capital improvements on the home. The adjusted basis is increased by additions and other improvements that have a useful life of more than one year, special assessments for local improvements, and amounts you spent after a casualty to restore damaged property. See IRS Publication 523 for details. Part of your cost basis is certain settlement or closing costs but not fees and costs for getting a mortgage loan. Chapter 13 of IRS Publication 17 has a list of settlement fees and closing costs that you can include in the cost basis of property.

There is a significant tax advantage with the sale of your main home. You may exclude up to $250,000 of the gain on the sale of your main home ($500,000 if you are married and file a joint return) if you meet the ownership test and the use test and if during the two-year period ending on the date of the sale, you did not exclude the gain from the sale of another home. This tax advantage pertains only to your main home. It does not pertain to vacation homes or rental property.

Ending on the date of the sale, you must have owned the home for at least two years and lived in the home as your main home for at least two years out of the last five years (or up to fifteen years for those in the military). If you do not meet the ownership and use rules, you may still claim a reduced maximum exclusion by reviewing all the details of your situation against the relevant tax code. IRS Publication 17 has a summary of these exceptions.

Long-term capital gains on financial assets such as stocks and bonds (or mutual funds holding stocks and bonds) are eligible for the preferred maximum tax rate of 15 percent. However, the sale of such items as collectibles (art, coins, stamps, bullion, etc.) held more than one year is taxed at a maximum rate of 28 percent.

Some mutual funds invest in gold and other alternative assets. How those funds are taxed depend on what is actually held in the fund. If the fund holds hard assets such as gold bullion, you will pay 28 percent capital gain taxes when you sell the fund or when assets in the fund are sold to meet redemptions. If the fund invests in derivatives such as future and swap contracts, a portion of the gain will be taxed as ordinary income and a portion will be taxed as long-term capital gains. See your 1099-DIV for a breakdown.

An entire chapter is devoted to understanding Social Security, and you should refer to that chapter for details. The focus in this chapter is on how these benefits are taxed. Social Security benefits are superprogressive. Not only does the tax on Social Security income increase as your income increases but also the percentage of the payment that is taxed goes up. It is a double whammy by Uncle Sam. For example, if you receive very little taxable income in addition to Social Security, then you are in a low tax bracket, and none of your Social Security is taxable. However, if you have substantial income beyond Social Security, then 85 percent of your benefit is taxable at a high marginal tax rate.

The alternative minimum tax (AMT) is an extra tax some people have to pay on top of their regular income tax. AMT rates start at 26 percent and move to 28 percent at higher income levels. By comparison, the regular tax rates start at 10 percent and then move through a series of steps to a high of 35 percent. You calculate the tax by completing Form 6251 provided by the IRS.

The original idea behind AMT was to prevent people with very high incomes from using special tax benefits to pay little or no tax. The AMT has increased its reach, however, and now applies to some people who don’t have very high income or who don’t claim lots of special tax benefits. Proposals to repeal or reform the AMT have languished in Congress for years. Until Congress acts, almost anyone is a potential target for this tax.

The name comes from the way the tax works. The AMT provides an alternative set of rules for calculating your income tax. In theory, these rules determine the minimum amount of tax that someone with your income should be required to pay. If you’re already paying at least that much because of the regular income tax, you don’t have to pay an AMT. But if your regular tax falls below this minimum, you have to make up the difference by paying an alternative minimum tax.

The AMT also eliminates itemized deductions, such as investment expenses, employee business expenses, and some medical and dental expenses. It also counts as income the interest from private-activity bonds, a type of tax-exempt bond issued by governments, usually to finance sports stadiums and the like. Finally, AMT rules force you to pay taxes on the spread between the market price and the exercise price of incentive stock options granted by your employer.

There are separate tax codes covering each of the 50 states, the District of Columbia, Puerto Rico, the Virgin Islands, and Guam. For the purpose of this book, all of these are classified as state taxes.

States have various means of collecting taxes from its residents. They include but are not limited to income tax, sales tax, real estate tax, and property tax. If you are considering relocating to another state, one of the factors to consider is the overall tax burden you will face for your particular situation. The Retirement Living Information Center has a summary of taxes for each state at
www.retirementliving.com
. Another useful site is from the Tax Foundation at
www.taxfoundation.org
. One of the tools compares each state’s tax rate across the years to the U.S. average state tax rate.

Tax rates run from a low of 0.36 percent in Iowa to a high of 11 percent in Hawaii. Most states have a progressive tax system similar to federal tax rates. All states have a minimum income below which no income tax is imposed. Then the rate goes up based on income. For example, Maryland has seven brackets ranging to $1,000 to $500,000.

Seven states have a flat tax, which means one tax bracket after certain deductions and exemptions. Those states are Colorado, Illinois, Indiana, Massachusetts, Michigan, Pennsylvania, and Utah. All taxpayers pay the same rate after meeting the minimum income threshold.

Seven states, Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming, have no income tax. New Hampshire and Tennessee only tax interest and dividend income.

Like federal income tax calculations, most states allow a deduction for your personal exemptions (yourself, your spouse, and your children). And like federal taxes, those exemptions can phase out at higher incomes. Colorado and Pennsylvania remain true to their flat tax philosophy and offer no personal exemption deduction.

Your federal income tax allows you to deduct your state income taxes on your federal return. However, only a few states (Alabama, Iowa, and Louisiana) allow the full federal income tax to be deducted on the state income tax return. A few others (Missouri, Montana, and Oregon) provide a deduction but limit the amount that can be deducted.

State sales taxes became increasingly popular after Congress changed the federal tax code to allow taxpayers to deduct state sales taxes. Sales taxes range from a low of 2.9 percent in Colorado to a high of 6.25 percent in California. States also vary on whether food or drugs are taxed and at what rates. Local municipalities often add their own sales tax to these state sales tax rates. (California and Virginia have a statewide 1 percent local sales tax.) Five states (Alaska, Delaware, Montana, New Hampshire, and Oregon) impose no sales tax.

States do not tax interest earned on U.S. Treasury securities, including savings bonds. Almost every state does not tax interest on its own state bonds, with the exception of most bonds issued in Illinois. A few states do not tax the interest on other state bonds, although that is rare. In addition, some states offer tax breaks for donations made for certain nonprofit activities.

Some states impose a tax on your property (such as a tax on your car that is charged annually when you renew your vehicle registration). This tax is calibrated to the market value of your vehicle and is deductible on your federal income tax. Personal property taxes are popular with city, county, and other local governments.

Although many communities extract local taxes, generally your largest local tax is your real estate tax. Real estate taxes are usually collected by counties, and the revenue is split between county use and public schools. The tax rates can be quite different from region to region. Real estate taxes are typically high when a state has low or no state income tax and low or no sales tax. Real estate taxes are deductible on your federal income taxes, along with sales taxes and state income taxes.