Another issue that we ran into this week concerned capital losses.  As many of you know, if you sell an asset such as a stock, you can have either a capital gain, or a capital loss.  Your gain or loss is determined by subtracting your basis (or cost) from the selling price.  If there is a profit you pay capital gains tax, and if there is a loss you can use it to offset other capital gains, or deduct up to $3,000 annually against ordinary income.

We all know the damage that has been inflicted on retirement accounts over the past few years, and deducting $3,000 a year is little consolation for those in, or near retirement.  If have a big capital loss sitting on the books, and you get a shot at a big capital gain, you may want to take it.  If you have a $100,000 capital loss rolling forward from a previous year, it can wipe out a $100,00 capital gain in the current year.  That sure beats trying to deduct $3,000 a year for the next 33.3 years.

Here is a little known fact about capital losses… if you pass away, your capital loss passes away with you.  Let’s say that a newly retired widow just lost $500,000 in the stock market (I have seen it first hand), and she lives another 20 years.  If she is only able to deduct $3,000 per year, that means $60,000 of her capital loss would be utilized, and the remaining $440,000 would be wasted!  The IRS doesn’t allow her to pass the capital loss along to her heirs, or a trust if one was in place.

Let’s say the above scenario involved a married couple.  The spouse would be entitled to half of the $440,000 capital loss.  Unfortunately, $220,000 worth of capital losses would be forfeited.  When a spouse dies, the survivor is faced with a lot of challenges, and their tax picture changes dramatically.  Losing $220,000 in deductible losses makes things even worse.

So, if you have the opportunity to use those capital losses, you may want to take a close look at doing some “tax harvesting” in your portfolio.  A wise financial person once said, “…a profit is a profit”, especially if you don’t have to pay tax on it!

Don’t forget… if you have a tax or financial question, more than likely the answer is, “It all depends…”

There is a lot of confusion out there about taxes, and the same topics come up year after year.  Last week we answered a lot of questions regarding the cost basis of inherited stock.

Generally, if you inherit stock from someone, your basis is the value of that stock on the day the person dies.  For example, your great uncle dies and leaves you some stock he purchased for $10,000 in Apple Computer.  On the day he dies it’s worth $100,000.  Your cost basis is $100,000 – which is often referred to as “stepped up” basis.

If you are married to someone it works differently.  Let say that a husband and wife purchase some stock in Apple Computer for $10,000.  The stock shoots up to $100,000, and the husband get so excited that he has a heart attack and dies.  His wife has to sell the stock to pay for the funeral.  Her cost basis is half of the original basis, and half of the value on the day that her husband died.

In this example the wife’s cost basis would be $55,000, or $10,000/2 + $100,000/2.  There is a lot of confusion on this particular point, because most things pass directly to the spouse with little or no tax implications.  Married couples that have a lot of assets should really consult with their tax & financial team, so that they can be properly informed to make decisions when one of them dies.

Next time I am going to be discussing the First-Time Homebuyers Credit.  See you then.

Don’t forget… if you have a tax or financial question, more than likely the answer is, “It all depends…”

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Don’t forget… if you have a tax or financial question, more than likely the answer is, “It all depends…”

Let’s go over some of the basics.  If you sell stock and lose money, it’s what’s referred to as a capital loss.  A capital loss is claimed on your tax return as a reduction to ordinary income.  You can only claim up to $3,000 in any given tax year ($1,500 if Married Filing Separately), unless you have gains to offset it.

For example, let’s say that you lost$112,000 on a series of trades earlier in 2009, and then had a $100,000 profit later in the year.  You would offset the $100,000 capital gain with your $112,000 capital loss, leaving you with a capital loss of $12,000.

You could then deduct $3,000 from your ordinary income, and carry the remaining $9,000 loss over to the following year (2010).  Again, if you didn’t have any gains to offset your loss, it would be depleted in 3 years.

For the most part, capital losses can be claimed until they are depleted.  The only real exception is in the event of the taxpayers death.  When someone dies, their capital loss dies with them.  This is especially important to be aware of if the spouse with the loss predeceases the one without a loss.

Excess capital losses are forfeited, and cannot be carried over to the surviving spouses 1040.  If the property was owned jointly by a decedent and a surviving spouse in a community property state, logic would dictate that the survivor would be entitled to half of the loss.

So the answer to the question is yes, there is a 0% capital gains rate in effect for the tax years 2008, 2009, and 2010. As usual, there are some significant caveats when it comes to utilizing them. Here are some of them:

• The 0% capital gains rate applies to long term (held over one year) investments only
• You must be in the 10% to 15% tax brackets to be eligible
• Sales of collectibles are not eligible for this treatment. Their cap gains rate remains 28%.
• Recaptured Section 1250 (depreciable real estate) gains are not eligible and are still taxed at 25%

Don’t forget, your capital gains need to be included in your taxable income when determining your tax bracket. Again, you pay 0% capital gains in the 10% & 15% brackets, but once you reach the next tax bracket (25%) your capital gains rate shoots up to 15%. If you are single you enter the 25% bracket at $32,551, and if you are married filing jointly you enter the 25% bracket at $65,101.

So, let’s say that you are married filing jointly, have a taxable income of $75,100, and $50,000 in capital gains. That would put you in the 25% tax bracket, and your capital gains would be taxed accordingly: $40,000 taxed at 0%, and $10,000 taxed at 15%.

I would suggest consulting with your tax & financial advisor before the end of the year. Each person’s situation is unique, but there are those that could benefit greatly from this.

Whichever boat you may be in, now is the time to carefully consider ANY financial move you might be thinking about. Bearing that in mind, let’s talk about capital gains derived from mutual funds. They get paid out annually, generally in December. For those of you who have suffered losses in your mutual fund portfolio, you may have an income tax hit looming as well.

Huh? What? How is that possible? My portfolio has suffered huge losses in asset value, and now I capital gains tax to look forward to? What gives?

Well, a mutual fund (by law), has to distribute its income to its shareholders. The funds don’t get taxed, you do.

A mutual fund derives income from its various holdings stocks, bonds, etc. and pays that income out to its shareholders. This generally occurs twice a year and is known as income distribution.

Capital gains are accumulated throughout the year and are generally paid out in December.

Many investors assume that they couldn’t possibly incur any capital gains because their funds have lost too much money. Unfortunately, that isn’t the reality of the situation. A decline in a mutual fund’s share price has more to do with losses in the value of its assets, not from losses in its portfolio due to stock transactions.

One of the reasons that a person buys a mutual fund is portfolio diversity, and another is to have a money manager running their portfolio. Most managers don’t operate like the general public, i.e. buying high and selling low. A lot of managers are holding assets in anticipation of a comeback, or even buying to take advantage of value. So, the end of the year comes along, and it’s time to distribute all of those capital gains that have been accumulating inside of the fund.

What does this mean to you? This might be a good time to consider dumping some of those funds that are not performing so well. If it suits your situation, you could sell now and avoid any potential tax hit. If you are considering buying a fund, you might want to wait until after the distribution date.

Before you anything, get a hold of the fund in question and ask them if they are going to have a taxable capital gains pay out. That should help you make a decision that’s right for you, and when in doubt, consult with a trusted advisor.

For more reading on the subject, consult the following article:

http://www.filife.com/stories/fund-investors-face-risk-of-tax-hit

Now is the time of year for us to do some financial planning. We need to be thinking about our money, along with all of our holiday festivities. Bearing that in mind, this is the first of many posts in which I will be addressing tax planning issues for the end of this year, and the beginning of the next.

The IRS has completed their inflation adjustments for the 2009 Tax Year. Many portions of the tax code are adjusted annually for inflation, among them being personal exemptions and standard deductions. If you care to look you can find all the details by clicking this link, Rev. Proc. 2008-66, or you can look at the summary that I have provided:

• Personal exemptions are now $3650 an increase of $150
• MFJ taxpayers will now have a standard deductions increase of $11,400 – a $500 increase
• Single taxpayers (and MFS) will now have a standard deduction of $5,700 – a $250 increase
• Taxpayers filing HoH taxpayers will now have a standard deduction $8,350 – a $350 increase

Other changes will include:

• The annual gift tax exclusion is now $13,000 – a $1,000 increase over last year
• EITC for families with two or more children will is now capped at $5,028, which is a$204 increase over last year. The income eligibility has also increased for MFJ filers with more than one child, you must now be under $43,415 to qualify

There has also been a change in the 2009 tax brackets. If you are a single taxpayer, your tax brackets are as follows:

• Taxable income up to $8,350 = 10%
• Taxable income over $8,350 to $33,950 = 15%
• Taxable income over $33,950 to $82,250 = 25%
• Taxable income over $82,250 to $171,550 = 28%
• Taxable income over $171,550 to $372,950 = 33%
• Taxable income over $372,950 = 35%

If you are MFJ your tax brackets will be:

• Taxable income up to $16,700 = 10%
• Taxable income over $16,700 to $67,900 = 15%
• Taxable income over $67,900 to $137,050 = 25%
• Taxable income over $137,050 to $208,850 = 28%
• Taxable income over $208,850 to $372,950 = 33%
• Taxable income over $372,950 = 35%

That’s all for today, but don’t worry, we will have a LOT more about the new tax law changes in the weeks to come. See you next time.

People usually associate the term tax rate with the tax bracket that they are in, which in my opinion is really a false indicator.  As we discussed previously, the tax brackets operate on a sliding scale.  If you are in the 25% bracket, all of your taxable income is not taxed at 25%, just the portion attributable to that bracket.

In 2008 if you are MFJ and in the 25% bracket your first $16,050 of taxable income would be taxed at 10%, the amount from $16,051 to $65,100 would be taxed at 15%, and anything from $65,101 up would be taxed at 25%.  As you can see, if you paid 25% on all of your taxable income, you would be cheating yourself!    

That’s why it is really important to know and understand your effective tax rate, which is your percentage of tax in relation to your total income (before deductions).  Again, your tax bracket is determined by your net income (after deductions).

Your effective tax rate is the real indicator of how much income tax you are paying throughout the year.  Let’s say that you are married with one child (13 years old), and have a combined income of $96,000.  After all of your deductions your taxable income is $56,850, which would put you in the 15% bracket, and give you a tax liability of $6,740 after credits.  Paying $6,740 in taxes is much more palatable than paying 15% of $56,850, which would amount to $8,528.

If you compare your $6,740 tax liability to your $96,000 total income, you can compute a 7.02% effective tax rate.  People with lower incomes, in lower tax brackets pay even less.  Based on IRS estimates for 2005 the average tax rate for 50% of American’s filing tax returns is 2.98%.

Clear as mud?  Take a look at the charts below and you can see for yourself.  A single person pays 10% tax on the first $8,025 of their taxable income. Than they pay 15% on anything over $8,025 but under $32,550.

A lot of people have the misconception that if they are in the 25% bracket, they pay 25% on all of their taxable income, and that simply is not true.

The truth is, most people don’t pay nearly as much Federal Income Tax as they think they do – which leads me into our next topic – effective tax rates.  Take care.

Very often someone will get tax advice from a friend or colleague, and because it is what they want to hear, they treat it as fact.  So, in the interest of separating fact from fiction, let’s start with a question that we get asked about quite a bit.

Do I have to file a tax return?  The answer is: that depends (the answer to most tax questions – hence all the confusion).  Paying taxes depends strictly on income. If you make over a certain amount of money, you have to pay taxes, and file a tax return.

The next question that usually follows is: how much can I make before I have to pay taxes?  That depends… are you married, single, or head of household?  How many dependents do you have?  What type of income are we talking about?  Are you self-employed, or working for someone else as an employee?  Are you retired and collecting Social Security?  Are you disabled?

Generally speaking, you add up all of your tax eligible income, subtract your standard deduction, then subtract your personal exemptions, and what you are left with is the income you pay tax on.  The following provides the standard deductions and personal exemptions for the 2008 tax year:

Standard deduction

·         Single = $5,450

·         Married Filing Joint (MFJ) = $10,900

·         Head of Household (HoH) = $8,000

·         Married Filing Separate (MFS) = $5,450

Personal Exemptions

·         $3500 (each)

Let’s say that a married couple has two children, and a combined income of $60,000 (tax eligible).  Their taxable income could be figured as follows: $60,000 – $10,900 (MFJ Standard Deduction) = $49,100, and then $49,100 – $14,000 ($3,500 x 4 Personal Exemptions) = $35,100 taxable income.  You then take your taxable income and apply it to the appropriate tax brackets to calculate your tax.

If you and/or your spouse are over the age of 65, or blind, you get an additional bonus of $1,050 per person, per event, added to your standard deduction.  There are many other factors to consider, but this is a very general way to calculate your taxable income.

My next post will cover tax brackets and how they work.  See you then.