One of the advantages of a "self directed" retirement is that you have some flexibility in managing your tax burden. By self directed, I mean one in which your income is primarily derived from your investments rather than a pension. In a previous article I described a Zero Percent Withdrawal Retirement Plan. Someone following a similar approach can exercise some discretion when it comes to taxes by controlling the mix of income and the total amount. Your income may consist of wages, taxable interest, ordinary dividends, Schedule K-1 income and/or capital gains.
Right up front, let's recognize that what I'm about to discuss cannot be used by everyone. Let's frame it somewhat. As stated above, your income is derived primarily from your investments. You are not yet subject to Required Minimum Distributions from your traditional IRA. I'm not going to address the effect of Social Security income here. It can complicate the issues, please consult your tax advisor. Also, I know that tax rates can and probably will change after 2012 but I can't control that. So I'm just going to address the rates we have today for 2011 and 2012. First, here are the tax brackets for 2012:
Married Filing Joint
Married Filing Seperate
Head of Household
Up to $8,700
Up to $17,400
Up to $8,700
Up to $12,400
$8,701 - $35,350
$17,401 - $70,700
$8,701 - $35,350
$12,401 - $47,350
$35,351 - $85,650
$70,701 - $142,700
$35,351 - $71,350
$47,351 - $122,300
$85,651 - $178,650
$142,701 - $217,450
$71,351 - $108,725
$122,301 - $198,050
$178,651 - $388,350
$217,451 - $388,350
$108,726 - $194,175
$198,051 - $388,350
Now for the real kicker: If you can live on an income that keeps your taxable income within the 15% bracket (or said differently, below the lower range for the 25% bracket) you will pay 0% tax on qualified dividends and 0% tax on long term capital gains. From the IRS website:
Qualified dividends are subject to the 15% rate if the regular tax rate that would apply is 25% or higher. If the regular tax rate that would apply is lower than 25%, qualified dividends are subject to the 0% rate.
Qualified dividends are subject to a holding period. You must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. Don't you just love the IRS? (There's a different holding period requirement for distributions from preferred stocks.) In essence, if you're working some type of dividend capture strategy to get in, collect the dividend and get out, that dividend will not be treated as a qualified dividend and therefore will not be eligible for the lower tax rate. Fortunately, for most of us, our broker will identify qualified dividends for us on the 1099-DIV so you don't have to worry about the holding period consideration.
Regarding the tax rate for LT capital gains, from the IRS website:
IF your net capital gain is from ...
THEN your maximum
eligible gain on qualified small business stock minus the section 1202 exclusion
unrecaptured section 1250 gain
other gain1 and the regular tax rate that would apply is 25% or higher
other gain1 and the regular tax rate that would apply is lower than 25%
1"Other gain" means any gain that is not collectibles gain, gain on small business stock, or unrecaptured section 1250 gain.
Note that we are talking about your taxable income, after deductions and exemptions. Naturally, your qualified dividends and LT capital gains are included in your taxable income. For example, a married couple filing jointly with $30,000 of regular income (wages, interest, etc.) could have at least an additional $40,000 of qualified dividends and LT capital gains that would be taxed at 0%; could be as much as an additional $59,000 considering $11,600 if using the standard deduction and $7,400 for personal exemptions.
For a retiree, this gives you the opportunity to reset your cost basis on some of your taxable holdings that have run up in price. If you have positions that you no longer want but have been hesitant to sell because of the long term capital gains, sell them now and pay no tax. Or, if you want to continue holding the stock, sell it and immediately buy it back. This gives you a new, higher cost basis lowering your future tax liability when the tax rates may not be as favorable.
I would point out that here we're talking about your federal taxes only. Your state taxes will vary and will likely not be as forgiving.
Here's one additional tip: If you find that you're well under the upper threshold for the 15% tax bracket, you might want to take advantage of that and do a partial ROTH conversion. If you have a traditional IRA you can convert a small portion of it each year, particularly if you will be taxed at the 15% rate. Over time, this will allow you to reduce the size of your IRA, which lessens the impact of Required Minimum Distributions. And by paying the tax now at 15% you avoid the possibly higher tax rate on that portion when you take your distributions in the future.
As previously suggested, please consult your accountant, CPA or other tax professional before taking any action on these ideas. The bottom line is that your opportunity to pay 0% tax on your dividends and LT capital gains may not be available after 2012. So, if you qualify, try to make good use of these tax rates.
Disclaimer: I am not a CPA or tax professional and cannot give you tax advice. You should consult a CPA or other tax professional before taking any action in planning your tax liability.