for the 2008–2010 Zero-Percent Adjusted Net Capital
Alan R. Sumutka, Andrew M. Sumutka, and Gina S. Margarido
DECEMBER 2006 - The
current ordinary income tax rates for individuals are 10%,
15%, 25%, 28%, 33%, and 35%. Certain capital gains and qualified
dividends (i.e., adjusted net capital gains) are taxed at
15%, or 5% for taxpayers in the 15% or 10% tax brackets. Pursuant
to the Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA) and extended by the Tax Increase Prevention and Reconciliation
Act of 2005 (TIPRA), the 5% rate drops to 0% from 2008 to
2010. In 2011, these rates will sunset and revert to the pre-2001
rates of 15%, 28%, 31%, 36%, and 39.6%. Qualified dividend
income (i.e., dividends from most domestic corporations and
certain qualified foreign corporations) will lose its favorable
status, and capital gains rates will revert to pre-2003 rates,
generally 20% (10% for gains in the 15% bracket) and the special
five-year holding period rules. Some commentators speculate
that, under certain circumstances, the favorable rates may
be rescinded after 2008, which is a presidential election
least for now, 2008–2010 are tax-advantaged years
for taxpayers with adjusted net capital gains (ANCG) in
the 10% or 15% tax brackets. Potential beneficiaries include
retirees, prospective retirees, some semiretirees, and parents
and children. With proper planning these taxpayers could
generate income, implement various asset management strategies,
or satisfy gift and income shifting objectives at no tax
favorable capital gains and qualified dividend tax rates
apply to ANCG. Technically, ANCG includes net capital gain
(NCG), defined as net long-term capital gains minus net
short-term capital losses, but excludes sales from collectibles,
IRC section 1202 qualified small business stock (both of
which are taxed at no more than 28%), and sales of depreciable
real property (i.e., unrecaptured section 1250 gain, which
is taxed at no more than 25%). ANCG also includes qualified
dividend income (QDI), as long as the dividends are not
treated as investment income when determining the amount
of deductible investment interest expense. For most taxpayers,
ANCG is simply the sum of net capital gains from the sale
of stock, bonds, or mutual funds, plus QDI.
5% or 0% rate applies only to the extent that ANCG would
be taxed at 10% or 15% if it was ordinary income. Otherwise,
ANCG is taxed at 15%. As illustrated in the following examples
(also see Exhibit
1), the favorable tax treatment afforded to (the $24,000)
ANCG depends on the amount of the taxpayer’s taxable
income minus ANCG (i.e., non-ANCG, such as interest income,
retirement plan distributions, and taxable Social Security
Example 1(a). If the total (non-ANCG)
ordinary income included in taxable income ($6,550) plus
the ANCG ($24,000) is less than the taxable income at
the top of the 15% bracket ($30,650), then all of the
ANCG ($24,000) is taxed at 5% in 2006–2007 (0% in
1(b). If taxpayer’s (non-ANCG) ordinary
income included in taxable income ($40,000) exceeds the
taxable income at the top of the 15% tax bracket ($30,650),
then the ANCG ($24,000) is taxed at 15% from 2006 through
1(c). If the (non-ANCG) ordinary income
included in taxable income ($20,000) is less than the
taxable income at the top of the 15% tax bracket ($30,650),
and the ANCG ($24,000) is partially below and partially
above the top of the 15% tax bracket, then only the part
below the top of the 15% bracket ($10,650) is taxed at
5% (0% in 2008–2010) and the remainder ($13,350)
is taxed at 15%.
tax savings from the 0% rate depend upon what the applicable
tax rate would otherwise have been. In Example 1(a), all
of the $24,000 ANCG is tax-free. Compared to the 5% rate
in 2006–2007, the 0% rate in 2008–2010 saves
the taxpayer 5% or $1,200 ($24,000 x 5%).If a taxpayer can
reduce the ANCG rate in 2008 to 2010 from 15% to 0%, the
tax savings are $3,600 ($24,000 x 15%). Compared to the
prospective 10% rate in 2011, if the $24,000 is NCG, the
0%-rate savings are $2,400 ($24,000 x 10% NCG rate). If
the $24,000 is QDI, however, the savings depend upon the
taxpayer’s ordinary income tax bracket, because QDI
loses favorable treatment in 2011. Any benefit is probably
valuable to most retirees and children.
Beneficiaries and Their Opportunities
individuals are unlikely to share the benefits. Those with
low incomes, although commonly in the 15% tax bracket, often
lack the wherewithal to save or generate ANCG. Middle-income
workers usually straddle the 15% and 25% brackets, but initially
save in tax-sheltered retirement accounts and only later
in taxable accounts. High-income earners exceed the tax
retirees. According to the U.S. Census Bureau,
approximately 40 million individuals will be age 65 or older
in 2010. In 2011, the first baby boomers turn 65. Those
contemplating early retirement between 2008 and 2010 may
be best positioned to exploit the 0% tax rates. Often new
retirees choose the source of their retirement income and
influence its amount and type by the timing and ordering
of retirement savings withdrawals. With no preset base income
(e.g., receiving no salary or being able to delay distributions
from a retirement plan and Social Security), even formerly
high-income individuals may be able to create a 15% tax
bracket for three years and redeploy or reallocate assets.
Tax-free draw-down from taxable accounts.
A common retirement income draw-down (i.e., withdrawal)
strategy is to liquidate taxable retirement accounts first
and permit tax-deferred accounts to grow. By liquidating
sufficient taxable capital assets to satisfy income needs,
a retiree could shelter the capital gains from taxation.
This strategy prolongs the deferral of tax-sheltered assets
and delays the need for Social Security, potentially increasing
the future benefits from both.
may be desired for other reasons, such as repaying debt
or funding a side account. Most draw-down research concludes
that annual withdrawals should be limited to approximately
4% of retirement asset values, plus the annual inflation
rate, in order to avoid asset depletion before death.
A side account supplements the reduced withdrawal amount
when asset values decline during a market turndown.
Portfolio management/tax-rate hedging.
Upon retirement, many taxpayers reduce equity exposure
and rebalance assets, usually those held inside a tax-deferred
account (to minimize the tax burden). With the opportunity
for tax-free capital gains, rebalancing may be accomplished
throughout the portfolio, including the revision of
asset-allocation percentages, the reallocation of individual
stock risk (i.e., the sale of appreciated stock), or
the substitution of more appropriate asset classes (e.g.,
stock into real estate). Others may seize the opportunity
to sell an appreciated asset to reset its basis to a
higher amount, such as by selling it, realizing the
tax-free gain, and repurchasing the same asset, or to
hedge against expected higher capital gains rates.
Miscellaneous asset sales. Sheltering
nonrecurring capital gains from the sale of a business
interest, rental property, or a principal residence in
excess of the home-sale exclusion may be possible. For
those holding appreciated company stock inside a company-sponsored
retirement plan, retirement may be the optimum time to
take a lump-sum distribution of company stock and generate
capital gains from the net unrealized appreciation.
Because many older retirees experienced the Great Depression,
they often saved regularly in taxable accounts [before 401(k)
plans existed], which now represent appreciated assets.
According to the 2006 Investment Company Fact Book,
in 2005, 37% of households aged 65 or older owned mutual
funds, mostly outside of a defined-contribution plan, and
another 37% of equity investors owned only individual stocks.
older retirees live frugally on modest incomes, typically
Social Security, pensions, diminishing traditional IRAs,
and QDI. As documented below, the median and mean incomes
for retirees qualify many of them for the 15% tax bracket.
This income creates a base amount that potentially hampers
their ability to fully capture the ANCG benefits. In some
cases added income from asset sales increases the amount
of taxable Social Security benefits, further increasing
the base amount.
retirees’ sheltering activities might be skewed toward
building cash reserves (e.g., for medical expenses or assisted-care
or nursing-home expenses), asset rebalancing (because many
of them forgo active personal portfolio management, opt
for buy-and-hold strategies, and use dividend-reinvestment
plans resulting in portfolio imbalance), or tax-rate hedging.
Semiretirees, who have delayed Social Security and retirement
plan benefits, may have tax planning opportunities. Having
retired early from a full-time, middle-income job and now
working at a lower-paying endeavor, the semi-retiree may
supplement lower (15% tax bracket) wages with assets from
other taxable retirement savings. The wages create a base
amount, however, limiting tax benefits.
and their children. Because many children
are in the 10% or 15% tax bracket, the gifting and income-shifting
techniques for parents are well known. Parents may gift
up to the annual exclusion (currently $12,000), presumably
in appreciated stock, to each child over the age of 13 to
avoid the “kiddie tax.” The child receives the
asset at its (lower) carryover basis, sells it at a gain,
and pays the 5% capital gains tax. The same strategy is
employed by other donors for other donees (e.g., grandparents
to TIPRA, after 2005 the kiddie tax applies to children
under age 18. The receipt or sale of assets by a child at
that time, typically the first year of college, may adversely
impact a student’s financial aid. Therefore, such
gifting (by parents or grandparents) and selling is best
deferred until after the child’s first semester of
junior year, when a student’s financial status is
no longer evaluated. Optimally, these years would be 2008,
2009, or 2010. After the child’s final semester, the
child may start full-time employment and exceed the 15%
tax bracket. For children not pursuing higher education
or ineligible for financial aid, these timing issues are
parents who contemplate making gifts to older children may
time their gifts so their children can take advantage of
the aforementioned opportunities available to them in retirement.
tax savings are maximized when retirement begins on December
31, because there will be no base amount on January 1 of
the following year. Nevertheless, the amount of the savings
depends on whether the retiree receives Social Security
Security recipients. This category generally includes
most prospective retirees, early retirees who are not yet
eligible for or have elected to delay Social Security benefits,
and the 12% of retirees age 65 or older who do not collect
Social Security (Congressional Research Service Report
for Congress, “Topics in Aging: Income and Poverty
Among Older Americans in 2004”; hereafter the CRS
Report). As previously noted, these individuals may be most
likely to fall in the 15% tax bracket.
the 5% or 0% rate applies to ANCG in the 10% or 15% brackets
only, generally the sum of the taxable income in these brackets
represents the maximum amount of ANCG that can be sheltered
tax-free each year. In 2006 the taxable income at the top
of the 15% tax bracket is $30,650 for single filers and
$61,300 for joint filers.
a 3% annual increase in the tax brackets, by 2010 these
upward limits are projected to approach $34,500 and $69,000,
respectively. If each taxpayer had the full 10% or 15% tax
brackets available for ANCG (i.e., had no non-ANCG), the
cumulative tax savings from 2008 to 2010 approximates $5,000
and $10,000, respectively (assuming 5% in 2007 versus 0%
in 2008). With different rate assumptions, the savings could
course, assuming that taxpayers will have only ANCG is unrealistic.
As Example 2(a) illustrates, in 2006 a single taxpayer under
the age of 65 can have up to $8,450 of non-ANCG sheltered
by the standard deduction ($5,150) and personal exemption
($3,300). Assuming a 3% annual increase in those deductions,
by 2010 the possible non-ANCG approximates $9,500 for single
filers, $19,000 for joint filers, and $10,900 and $21,300,
respectively, for single and joint filers age 65 or older.
Although these amounts are modest, these individuals are
well positioned to manipulate their non-ANCG.
amount of non-ANCG can exceed these limits if a taxpayer
has deductions for adjusted gross income (AGI) or itemized
deductions. As Example 2(b) illustrates, the full $14,300
of non-ANCG is sheltered by deductions for AGI ($1,000),
itemized deductions ($10,000), and personal exemptions ($3,300),
which provides the taxpayer with a non-ANCG limit greater
than the standard deduction.
Examples 2(c) and (d) in Exhibit 1 illustrate, if a taxpayer
has income exclusively from ANCG, the various deductions
provide the opportunity to increase the amount of ANCG beyond
the standard deduction and personal exemptions.
Security recipients. According to the CRS
Report, in 2004 approximately 35.2 million individuals were
age 65 or older and 88% received Social Security. Their
median income was approximately $15,000, which included
about $10,400 in Social Security and $950 in income from
assets (e.g., interest, dividends, rents, and royalties).
Extending this data to couples, the median income was about
$30,000 ($20,800 in Social Security; $1,900 in income from
assets). Using a 3% annual increase, in 2006 the median
incomes for individuals approximate $16,000 ($11,000 from
Social Security; $1,000 in income from assets) and $32,000
for couples ($22,000 from Social Security; $2,000 in income
from assets). Therefore, the tax bracket of Social Security
recipients at the median income level is no higher than
Security recipients, too, can shelter non-ANCG up to at
least the sum of the standard deduction plus personal exemptions
(in 2006, $9,700 for single filers and $18,900 for joint
filers age 65 or older). As Example 3(a) in Exhibit 1 illustrates,
a single taxpayer age 65 or over who receives income of
$11,000 in Social Security and $5,000 in other non-ANCG
is taxed on only $4,500 of the Social Security; all of the
non-ANCG (including Social Security) is sheltered. This
provides the opportunity to shelter all of the $23,500 in
ANCG from capital gains taxes. Again, the ANCG amounts could
be higher if the taxpayer had higher deductions for AGI
or itemized deductions.
non–Social Security recipients, however, Social Security
recipients cannot maximize their tax savings by increasing
ANCG to the top of the 15% tax bracket ($30,650), because
as ANCG increases, the amount of taxable Social Security
might increase. [Depending on the amount of the taxpayer’s
provisional income (generally, AGI excluding Social Security,
plus tax-exempt interest and 50% of Social Security), the
amount of Social Security subject to taxation approximates
0%, 50%, or 85%.] As Example 3(b) in Exhibit 1 illustrates,
an increase in ANCG (from $23,500 to $30,650) increases
the amount of taxable Social Security (from $4,500 to $9,350)
and the amount subject to regular tax rates (from $0 to
$4,650), which reduces the benefit of ANCG.
an increase in non-ANCG above the median income can increase
the taxable amount of Social Security, also decreasing the
ANCG eligible for sheltering. Example 3(c) in Exhibit 1
illustrates the outcome, assuming the higher estimated 2006
mean income per person of $25,300 ($11,300 from Social Security
and $5,700 from income from assets). In this example, only
$14,350 of ANCG is tax-free, and $8,800 of non-ANCG is taxed
at regular rates.
summary, tax planning is more complicated for Social Security
recipients. To quickly estimate the minimum amount of ANCG
that can be sheltered, assume that 85% of Social Security
is taxable (therefore, additional ANCG will not increase
it) and add it to other non-ANCG. Compare this total non-ANCG
to the total deductions available to shelter it. Only if
the total deductions exceed the total non-ANCG will the
full 10% or 15% bracket be available for ANCG.
management uses traditional income/deduction shifting techniques.
The goal in this case would be to minimize taxable income
to ensure a taxpayer remains in the 15% tax bracket from
2008 through 2010. The examples below assume that, 1) without
planning, the taxpayer would exceed the 15% bracket or be
unable to fully exploit it, and 2) any ordinary income shifting
between years would not increase the taxpayer’s marginal
tax bracket. Any loss in monetary value due to accelerated
tax payments will be ignored; this should be more than offset
by the tax savings from avoiding the higher ordinary rates
income. For projected 2008–2010 income,
the goal is to exclude it, accelerate it into 2006 and 2007,
defer it to 2011, or convert it to ANCG. Many techniques
pertinent to retirees reduce provisional income also, which
reduces taxable Social Security benefits.
Shelter wages (earned by semiretirees) by maximizing 401(k)
plan or savings incentive match plan for employees (SIMPLE)
Monitor fixed-income (e.g., certificates of deposit) investment
maturities; consider accelerated redemption. Use Series
EE or I bonds to defer interest.
Convert taxable interest-yielding investments into tax-free
money-market funds or municipal bonds if the tax-free
yields are comparable to taxable yields.
ordinary dividends from taxable money market funds to
the desirability of real estate investment trusts (REIT),
which generate nonqualified dividends.
traditional IRAs (common for older retirees) with small
balances to Roth IRAs to avoid minimum-distribution requirements.
Eliminate the possibility of state income tax refunds
by owing state income taxes.
If contemplating a lump-sum distribution of appreciated
company stock, determine its original cost basis, which
is taxed as ordinary income upon distribution.
deductions. For projected 2007 deductions,
the goal is to defer them to 2008 (and possibly maximize
them in 2008 if the results of the 2008 elections portend
repeal of the favorable tax rates). These techniques include
well-known “bunching strategies” for medical
deductions (to exceed the 7.5% AGI floor) and charitable
contributions, forgoing prepayment of fourth-quarter estimated
state income tax payments, converting consumer loans into
home equity loans to generate tax-deductible interest, and
funding traditional IRAs to shelter wages.
income. Income surprises tend to disrupt even
the most effective tax-bracket management.
For taxpayers who itemize deductions, the tax benefit
rule can trigger income from items such as reimbursements
for medical expenses or property tax rebates for prior
the amount and character of mutual fund distributions
are unknown until distribution. New fund purchases made
before the year-end distribution date can exacerbate the
consideration received by stockholders as a result of
merger activity can generate ordinary income.
The U.S. Government Accountability Office
report GAO-06-603 (June 2006) offered the following conclusions:
“[F]or tax year 2001, an estimated 38 percent of individual
taxpayers who had securities transactions failed to accurately
report their capital gains or losses from transactions (8.4
million out of 21.9 million taxpayers).” Of those
taxpayers, 97% misreported stock and mutual fund transactions
and 5% misreported bonds, options, or futures transactions;
64% underreported income and 33% overreported income; and
9% misreported the holding period.
potential errors seriously undermine the tax planning process.
Upon audit, corrections to underreported income and holding
periods can reduce the amount of ANCG eligible for favorable
calculations. The GAO concluded that the errors
occurred “often because [taxpayers] misreported the
securities’ cost basis.” The most common reasons
for misstatement were inadequate records, use of original
cost basis instead of adjusted cost basis (e.g., failure
to consider stock splits), inadequate understanding of basis
calculation rules, erroneous calculations by tax return
preparers, and incorrect broker-provided basis information.
stock basis is relatively straightforward when one’s
records are complete. This task can be challenging, however,
for those with inadequate records. Problems can be most
pronounced for older taxpayers, especially those who made
purchases many years ago, participated in dividend reinvestment
plans (DRIP), held stocks that split or had spin-offs, or
sold partial positions of their holdings. Equally difficult
are calculations for those who purchased mutual funds and
reinvested dividends before mutual fund companies began
to provide basis data. Anecdotally, some older taxpayers
elect to hold securities that were purchased years ago and
whose investment characteristics changed and no longer meet
their investment objectives, simply because they do not
know the basis. They rationalize that the securities will
be bequeathed to heirs who will receive a step-up in basis
basis requires establishing the amount invested in a stock
(usually original and additional purchases plus dividend
reinvestments) and the allocation of costs resulting from
stock splits and dividends and mergers and divestitures.
the problematic task is determining the basis of stock from
reinvested dividends. Financial websites are particularly
helpful. For example, information at Yahoo Finance (online
at finance.yahoo.com) provides historical dividends, stock
prices, and stock-split information on a daily, weekly,
or monthly basis. As an example, Exhibit
2 depicts a portion of the historical information for
information is listed chronologically and demonstrates the
availability of daily prices, dividend, and stock-split
information. Particularly useful for participants in the
company’s stock reinvestment program is the capability
to display only dividends and stock splits.
useful feature of this and other financial websites is the
ability to download data to an Excel spreadsheet. Once the
information is downloaded, rows can be inserted to show
initial and subsequent purchases using that dividend and
price information to identify the shares purchased and their
specific basis. This is particularly helpful for investments
that vary widely in price over time.
a company history is essential for stock acquired via spin-offs,
stock dividends, and stock as payment for mergers. Exhibit
3 shows the extensive, complex lineage of AT&T Corp.,
stock widely held by today’s retirees. The exhibit
shows the initial divesture of AT&T Corp. on January
1, 1984, and the subsequent divesture or spin-offs and the
new corporations. The percentages shown in each block are
the percentages of the parent’s total cost basis allocated
to the new corporation. The lineage chart provides the information
needed to research stock basis. A company’s website,
typically under “investor relations,” generally
presents basis allocation data, often with online or downloadable
worksheets and examples. Brokerage firms often provide similar
data to their clients. For example, the SBC/AT&T investor
relations website (www.att.com/ir) offers worksheets to
determine the cost basis of shares of AT&T and their
records must be sufficient to withstand audit and to identify
per-share costs and holding-period data in order for stock
sales to be tax-efficient. Unless the basis of stock sold
is specifically identified, the default basis is calculated
by the first-in, first-out method (FIFO). Mutual funds are
treated similarly, with an additional option to use average
loss management. Taxpayers should plan to
use tax-loss carryforwards prior to 2008, so that they will
not offset tax-free capital gains in 2008–2010.
Considerations and Risks
costs. Tax planning is too inexact to predict
whether the tax savings will outweigh the potential tax
planning/preparation costs (e.g., basis calculations) or
transaction costs of liquidating assets. Will some ANCG
be taxed at 15% rather than 0%? Even if ANCG is excluded
for federal purposes, will the accelerated gain recognition
increase state income taxes? Planning is geared toward 2008—a
presidential election year, which historically brings volatility
to securities markets. Deferring 2006–2007 unrealized
gains to 2008 may risk a decline.
step-up. Will elderly taxpayers balk at liquidating
securities positions when, upon their death, their heirs
receive them income tax free with a step-up in basis at
no cost (depending on the size of the estate and prospective
estate tax changes in 2011)?
assistance. Sometimes senior citizens receive
income-based assistance (e.g., state-financed drug or property-tax
relief programs). Added ANCG could disqualify them from
planning. Gifting has tax advantages, but
these transfers could delay Medicaid eligibility. Because
the states want to ensure that individuals do not qualify
for Medicaid by purposely transferring their assets to others,
they now review the propriety of transfers made during the
last five years (instead of three).
R. Sumutka, MBA, CPA, is an associate professor
of accounting at Rider University, Lawrenceville, N.J.
Andrew M. Sumutka, PhD, is an assistant professor
of management at York College of Pennsylvania, York, Pa.
Gina S. Margarido, MAcc, is a graduate assistant
at Rider University.