A client recently posed the question: “Is it true that there is a zero tax rate on capital gains?” Yes, a zero tax rate exists. It is limited however as to who may reap the benefits of the zero tax rate. Internal Revenue Code section 1(h)(1)(B) was amended by Public Law 108-27. For tax years 2008 through 2012 with respect to taxpayers in the 10% or 15% tax bracket, the long-term capital gain (assets held greater than one year) and qualified dividend maximum tax rate was reduced to zero percent.
Effective January 1, 2013, all capital gain rates will revert to pre-2003 levels (unless Congress extends the current law). An individual’s tax bracket is determined not by gross income or adjusted gross income (AGI), but by taxable income. Taxable income is computed after itemized deductions or the standard deduction and personal exemptions are subtracted from AGI.
Is this a sure-fire winner? Like so many provisions of the tax code, it all depends upon your individual circumstances. First, how many persons in the 10% and 15% tax brackets have the ability to generate or have unrealized capital gains? If you are thinking of transferring those appreciated stocks to your children and having them sell the stock and pay no tax, think again. Under the “kiddie tax” rules, if a child age 18 or younger (or up to age 23 if a full-time student) has investment income of more than $1,900, those capital gains are taxed at the parent’s tax rate, not the child’s rate. Persons who are receiving social security benefits could find themselves having more of their social security benefits taxed if they generated additional capital gains. The zero rate does not apply to retirement funds because any appreciation in those funds are not subject to income taxes until distributed, and then ordinary income tax rates apply to distributions (with the exception of Roth plans which are not taxed when distributed).
How do you know if you can benefit from the zero capital gains rate? The answer is quite simple. Consult with a competent tax advisor who is familiar with your tax situation and who can compute projections of your taxable income and the amount of long-term capital gains that you can realize and pay no taxes on those gains because your taxable income does not exceed the 15% tax bracket threshold.