A Capital Spring
Don't you just love this time of year?

by Ann Coleman

Washington, DC area (April 6, 1999) -- The cherry trees are blooming around the Tidal Basin, the dogwood buds are starting to swell, and every wide spot next to the road is home to a host of golden daffodils, so let's talk taxes.

Foolish Four investors who are not investing within a tax-friendly retirement account will pay taxes both on dividends received and on the increase in the value of any stocks they sold last year. Dividends are taxed as ordinary income, like interest from your checking account, but capital gains get special treatment. They are also somewhat misunderstood.

For one thing, the long-term capital gains rate is not necessarily 20%. That is the figure that is widely quoted, but the 20% rate applies only to taxpayers in the 28% or higher tax bracket. If you are in the 15% tax bracket, or don't have enough earned income to be in a tax bracket at all (for example, children), the long-term rate is only 10%.

Capital gains come in two flavors: Long-term and short-term. They are all capital gains, but the rate for short-term gains is the same as your "marginal tax rate" for earned income. Oops, guess we need a digression, here.

Marginal tax rate means the same thing as "tax bracket," which is what determines your long-term capital gain tax rate. Since our taxes are progressive, single taxpayers, for example, pay 15% on the first $25,350 of earned income, 28% on the next $35,000 or so, 31% on the next sixty-six thou, etc., until they hit $278,400. After that it's 39.6% on everything. (See 1998 Tax Rate Schedules (Over $100,000) for the real numbers. You can find your tax bracket here, too.)

The progressive nature of our tax system has some interesting side effects. Someone just barely over the line -- say, someone single with a taxable income of $26,000 -- will pay a tax equal to 15.3% of her taxable income although, technically, she is in the 28% tax bracket. Her marginal tax rate (that really is a better term than tax bracket) is 28% because once she hits the $25,350 mark, every additional dollar she earns is taxed at that rate.

This has rather profound implications that are far too complex to go into here, but let's look at one or two. Even though our hypothetical taxpayer is only paying 15.3% in taxes, every tax deduction she took was worth 28% because it offset income that would have been taxed at the higher, marginal tax rate.

If you have done your own taxes, you will have noticed that you start off with your actual income, which gets reduced by deductions and exemptions until you finally arrive at a "taxable" income. Those deductions and exemptions come off the top -- they reduce the money that would have been taxed at your highest rate. If you can itemize your deductions, do it -- even if only to see what might happen. In fact, it's a great idea to do your own taxes by hand at least once just to see how the process works. You'll have a much better appreciation of deductions after that.

Those deductions can be even more valuable if you have capital gains: If our hypothetical taxpayer could get her taxable income down another $700, her capital gains rate would drop from 20% to 10%. That's something to consider next time someone asks for a donation to a worthy cause.

Capital gains are absurdly easy to calculate. You don't have to worry about deductions, tax credits, personal exemption, etc. If you want to quickly estimate how your tax will affect a particular trade, you can simply subtract your purchase price (adding the commission to it first) from the selling price (you can deduct the commission from it first), and multiply by either 10% (0.1) or 20% (0.2). (On Schedule D this is all done by time period category, with losses subtracted from gains before the tax is calculated.)

In some respects, it is a very simple tax. Then again, there is the whole year-and-a-day thing. On Schedule D, your capital gains taxes will be separated into long-term (taxed at either 10% or 20%) or short-term (taxed at your marginal tax rate). To qualify for long-term treatment, an asset must be held for more than one year. This means that if you buy a Foolish Four stock on December 15th, hold for a year, and sell on December 15th, you will pay at the short-term rate, which could be as high as 39.6%. (What's your marginal tax rate?) If you hold it until December 16, you can move it to the long-term capital gains column and pay only 20% (10% if you are in the 15% bracket). This is not something you would want to mess up. Consult paper records for the date -- don't rely on memory.

Tomorrow -- more on capital gains, including the 18 month conspiracy.

Fool on and prosper!

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Today's Stock Lists | 1999 Dow Returns

04/06/99 Close
Stock  Change   Last
CAT  -  11/16  48.38
JPM  -1  7/8   123.94
MMM  -1  1/16  71.94
IP   +   1/8   43.63

                   Day   Month    Year   History
       FOOL-4   -1.05%   2.68%   5.60%   7.17%
        DJIA     -0.44%   1.81%   8.90%   8.47%
        S&P 500  -0.24%   2.45%   7.53%   7.79%
        NASDAQ   +0.12%   4.12%  16.90%  18.50%

    Rec'd   #  Security     In At       Now    Change

 12/24/98    9 JP Morgan    105.51    123.94    17.47%
 12/24/98   24 Caterpillar   43.08     48.38    12.29%
 12/24/98   22 Int'l Paper   43.55     43.63     0.17%
 12/24/98   14 3M            73.57     71.94    -2.22%

    Rec'd   #  Security     In At     Value    Change

 12/24/98    9 JP Morgan    949.62   1115.44   $165.82
 12/24/98   24 Caterpillar 1034.00   1161.00   $127.00
 12/24/98   22 Int'l Paper  958.12    959.75     $1.63
 12/24/98   14 3M          1030.00   1007.13   -$22.88

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4286.61