Some Common Investments Enjoy Preferential Tax Treatment

Although there are a variety of sophisticated tax shelters available, our tax laws also afford special tax treatment to certain common types of investments. Used appropriately in conjunction with sound tax and investment planning, these special benefits may produce a higher after-tax return on your investment dollars.

Dividends:
Through 2012, most dividends received by an individual shareholder from domestic corporations (and certain foreign corporations) are treated as net capital gain for purposes of applying the capital gain tax rates. This means qualifying dividends are taxed at 15% for taxpayers whose marginal rate is 25% or higher, and 0% for those in the 10% and 15% Tax Brackets.  These rates apply through 2012.  The net tax savings for each marginal tax bracket is illustrated below.

Tax Bracket

Qualified Dividend Rate

Net Tax Savings

10%
15%
25%
28%
33%
35%

0%
0%
15%
15%
15%
15%

10%
10%
15%
13%
18%
20%

Even though dividends are taxed on the Schedule D, dividend income cannot be offset with capital losses. Dividends on stock held in a retirement plan or traditional IRA will not benefit from the lower rates; distributions from these plans continue to be taxed at ordinary income rates.

Municipal Bonds: Although they generally pay a lower interest rate, their "after- tax" return can be higher than other similar investments such as corporate bonds, CDs, etc. Taxpayers in higher tax brackets and children subject to the "kiddie tax" frequently use this investment. If your state has income tax, you should note that most states will only allow the exclusion of interest on municipal bonds issued from that particular state or municipalities within that state. Municipal bonds can be purchased directly or investments can be made through a variety of municipal bond funds, many of which specialize in bonds from a specific state. Taxpayers drawing Social Security benefits should be reminded that even though municipal bond income may be tax-free, it is still used as income for purposes of determining the taxable portion of Social Security income.

Capital Gains: Gain from investments such as stocks, mutual funds, land, real estate, etc., are taxed at rates lower than an individual's regular tax rate if they are held over one year. Gains from such assets are generally taxed at 0% for tax years 2008 through 2012 if you are in the 15% tax bracket or below, or 15% if you are in the 25% or higher tax bracket.

Interest for Direct U.S. Government Obligations: This category includes U.S. Savings Bonds, T-Bills, H Bonds, etc. Interest earned on these obligations is taxable only for Federal purposes. Federal law prohibits states from taking a bite out of this income. Taxpayers that wish to reduce their state tax liability will greatly benefit from these investments. In addition, Savings Bond interest can be deferred until the bonds are cashed or reach maturity, providing a valuable tool for deferring income to some future tax year. Children, who are still dependents of their parents and have a lower standard deduction, can use the bonds to defer their income to a year when they get benefit of the full standard deduction, personal exemption, and lower tax rate. If that same child attends college, they may be able to offset the income with education credits.

Education Savings Bonds: Interest you receive from the redemption of U.S Series-EE savings bonds purchased after 1989, or Series I bonds, and after attaining the age of 24, held in your name or jointly with your spouse, may be excluded from income to the extent you pay qualified higher education expenses. The expenses must be for you, your spouse or a dependent and must have been paid during the same year the bonds were redeemed. The tax benefit has limited application since the benefit is phased out for taxpayers with higher incomes. For 2011, the phase out begins at $71,100 (up from $70,100 in 2010) for singles and $106,650 (up from $105,100 in 2010) for those filing jointly. The exclusion is completely phased out by the time singles reach $86,100 (up from $85,100 in 2010)  and $136,650 (up from $135,100 in 2010) for joint filers. If you are considering this strategy, keep in mind the income phase out is based on the year the bonds are redeemed and not the year they are purchased.

If we can assist you with the application of any of these strategies to your particular situation, please give us a call.