An article in the June 2013 issue of Forbes magazine certainly raised a few eyebrows in tax circles. According to the writer, William Baldwin, affluent retirees earning hundreds of thousands of dollars a year may actually pay zero federal income tax this year.
The article supplied the numbers to back up its claim and showed taxpayers how to do it.
Strategy: Load up on tax-favored investments in your portfolio. Current law encourages investors to take advantage of several key provisions permanently extended by the American Taxpayer Relief Act of 2012 (ATRA).
Here’s the whole story: Under ATRA, the maximum tax rate for qualified dividends remains at 15% for most individuals, although it increases to 20% for certain upper-income investors. What’s more, you’re taxed at a 0% rate on taxable income realized up to a specific point. For single filers, the threshold is taxable income of $36,250; it’s $72,500 for joint filers.
When you combine this critical tax break with other investment-related tax benefits, the tax savings can be astronomical. The Forbes article provides several examples:
Example 1: A hypothetical retired couple own a $2 million home, have $7 million stashed away with a broker and haul in $200,000 a year in dividends, interest, Social Security and distributions from publicly traded partnerships. They have $30,000 in deductions, including $20,000 for property tax and $5,000 for a donation. Typing these facts into Intuit’s TurboTax program produced a federal income tax bill of $17.
Example 2: An actual married couple is living off $216,000 a year, including $75,000 of municipal bond interest, $6,000 of taxable bond interest, $70,000 of dividends, $25,000 of taxable pensions and $40,000 of Social Security. Their federal income tax bill comes to $198.
Example 3: A widow receives $166,000 income from dividends, bond coupons, a private pension and Social Security. She owes only $261 in federal income tax.
Forbes says that this perfect storm of tax breaks is more common to senior citizens, but they don’t have exclusive domain. The results would be similar for a self-employed consultant who stashes most of his or her earnings in tax-sheltered retirement accounts. It could also work for someone enjoying a lavish lifestyle due to a large inheritance or other windfall.
The article offers these recommendations for joining the party.
- Search for companies paying dividends that qualify for the reduced tax rate. This includes most U.S. corporations (but not real estate investment trusts) and a surprising number of foreign corporations.
- Utilize the foreign tax credit. For example, the dividend yield on Total, the French oil company, is more than 4% even after French withholding, which offsets your U.S. tax liability.
- Sell losers from your stock portfolio and let the winners ride. Overall losses of up to $3,000 a year can offset highly taxed ordinary income.
- Defer Social Security and IRA distributions until age 70. Live off non-IRA assets.
- Once you pass age 65, consider buying energy partnerships. Their taxable income, which is low or nonexistent in the early years, rises sharply after a decade or two, but the deferred taxes are erased on inherited shares.
Baldwin also discusses specific investments. You can read the entire article, "How Retirees Pay Zero Taxes," at the Forbes website.
Tip: We would be remiss if we did not point out that the article doesn’t mention the new 3.8% Medicare surtax.
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