Low-income tax break won't affect IRA, 401(k)

Your Money

October 22, 2006|By Humberto Cruz | Humberto Cruz,Tribune Media Services

I read your article on the elimination of long-term capital-gains taxes for lower-bracket taxpayers from 2008 through 2010. My plan is to make withdrawals from my deductible IRA those three years to take advantage of this law. Do you agree?

Sorry, but withdrawals from IRAs do not qualify for this tax break. Such withdrawals are considered ordinary income and not capital gains, even if the account has gains from the sale of securities such as stocks, bonds or mutual funds. The money withdrawn would be taxed at your tax bracket, the same as other ordinary income such as pay from work, plus generally a 10 percent penalty if you are under 59 1/2 .

Likewise, withdrawals from other tax-deferred accounts such as 401(k)'s and other employer-sponsored retirement plans, and even non-qualified annuity contracts, are taxed as ordinary income, not capital gains.

And any gains from cashing in U.S. savings bonds are considered interest and also not eligible for the preferential tax treatment.

Incidentally, this significant break for lower-bracket taxpayers remains a secret to many. Every week, I receive at least a couple e-mails from readers who tell me I am wrong because they checked with their accountants and/or the IRS, and nobody had ever heard of it. But the zero-percent tax rate for long-term capital gains in 2008 to 2010 for taxpayers in the 15 percent and lower tax brackets is spelled out in the Tax Increase Prevention and Reconciliation Act passed by Congress in May.

Perhaps so many people remain unaware of it because the media have focused almost exclusively on another provision: the two-year extension (2009 and 2010) of the maximum 15 percent tax rate for qualified stock dividends and long-term capital gains, which had been set to expire after 2008.

But it bears repeating that 15 percent is the maximum rate, applying only to the approximately one-fourth of American taxpayers who are in the 25 percent tax bracket and higher. For the rest of us, the tax rate on both dividends and long-term capital gains (from the sale of securities held more than a year) is just 5 percent in 2006 and 2007 and zilch in 2008, 2009 and 2010.

Any qualified dividends you receive and long-term capital gains you realize count as part of your income when determining your tax bracket.

For example, a married couple filing a joint return can have taxable income as high as $61,300 in 2006 and stay in the 15 percent tax bracket. Because bracket figures are adjusted for inflation each year, we'll assume the top of the 15 percent tax bracket would rise to $65,000 in 2008. Let's say this couple has $50,000 in taxable income not counting any qualifying dividends or long-term capital gains in 2008. They could then have as much as $15,000 in combined long-term gains and qualifying dividends and pay no additional tax.

But if dividends and long-term gains combined exceed $15,000, the amount over $15,000 would be taxed at 15 percent.

My daughter, who is 30, bought a flexible premium deferred annuity six years ago. The annuity date is listed as April 6, 2065. Does that mean she will not be able get her money until she is 90?

No. Your daughter can get her money any time she wants, although before age 59 1/2 she will owe a tax penalty on top of regular taxes on any gains. (Aside from any taxes or penalty, since she bought the annuity six years ago, there may be surrender charges left - 10 years is usually the maximum they last.)

The annuity date means that if your daughter has not cashed in the annuity by then, she must annuitize, that is, convert the account value to a series of payments for life rather than take it as a lump sum. All deferred annuities must impose this requirement at some point - age 90 is common - to qualify for tax-deferred status. The term "flexible premium deferred annuity" simply means your daughter can add to the account any time she wants, and all gains will accumulate tax-deferred.


Humberto Cruz writes for Tribune Media Services.

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