With the passage of the American Taxpayer Relief Act of 2012, P.L. 112-240, taxpayers can continue to save significant taxes on qualified dividends and long-term capital gains.
Excluding the special 25% and 28% rates, Sec. 1(h)(1) now provides for three rates on qualified dividends and long-term capital gains (preferential income): 0%, 15%, and 20%. The 0% rate is available for preferential income in the 10% and 15% brackets. For qualified dividends and long-term capital gains in the 39.6% bracket, the tax rate is 20%. Preferential income in any other bracket is taxed at 15%.
When taxpayers have both ordinary and preferential income, additional deductions can create a multiplier effect that enables them to save at higher rates than their marginal rates on ordinary income. This phenomenon occurs when a deduction offsets ordinary income and shifts preferential income from the 25% to 15% (or 10%) bracket or from the 39.6% to 35% (or lower) bracket.
Example 1: Taxable income $142,500. Assume José and Janet, a married couple filing jointly in 2013, have taxable income of $142,500, including $67,500 of ordinary income and $75,000 of qualified dividends and long-term capital gains. Their tax is:
(The complete tax rate schedule is available in Publication 505, Tax Withholding and Estimated Tax, page 36 (2013), at tinyurl.com/ldfpzx.)
In this example, $5,000 of the 15% bracket remains after including the $67,500 of ordinary income. These qualified dividends and long-term capital gains are taxed at 0%. The remaining $70,000 of preferential income is taxed at 15% because the income is in the 25% bracket.
Example 2: Taxable income $129,500. Now assume José and Janet, both age 63, are eligible to contribute to traditional IRAs, and they both make $6,500 deductible contributions. This deduction lowers their taxable income to $129,500 ($142,500 ‒ $13,000). Their tax is:
Thus, even though the $13,000 deduction offsets their ordinary income in the 15% bracket, José and Janet actually save 30% ($3,900 tax savings ÷ $13,000 deduction) by making the contributions. This percentage decrease results from the 15% bracket tax savings from the ordinary income offset and the additional 15% bracket tax savings from the preferential income shift from the 25% to the 15% bracket.
A similar result can occur when an individual has ordinary income along with preferential income in the 39.6% bracket that can be shifted to a lower bracket.
Ways to Realize More Deductions
The multiplier effect is most likely to affect retirees who have investment income and some ordinary income (pensions, Social Security, or wages/self-employment income from part-time work). Common ways to create additional deductions include contributing to retirement plans (when eligible) and bunching itemized deductions such as real estate taxes and charitable contributions. If ordinary income is reduced by IRA or 401(k) contribution deductions, the multiplier effect may be partially offset by those contributions’ potential future taxability upon their distribution. However, proper planning can potentially reduce this negative impact. Tax practitioners should plan accordingly (and use projection software when necessary) so their clients can achieve the maximum savings.
By Seth M. Colwell, CPA, M. Tax. (firstname.lastname@example.org), a lecturer at the University of Texas at Brownsville.
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