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Buy These Stocks and Stiff the IRS

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As tax time starts moving into full swing, everyone wants to find ways to pay as little tax as possible. Many investors don't realize that they may be able to take advantage of tax-free treatment for the income they earn on their investments -- without even having them in a retirement account.

When you talk about avoiding taxes on your investments, the natural first thing most people think of is opening a Roth IRA. With a Roth, you don't have to pay taxes on your capital gains and investment income while your Roth is growing. And even better, when you withdraw money from your Roth after you retire, those withdrawals are tax-free as well.

But in certain cases, you can pay nothing in taxes even on investments you have in a regular taxable account. Here's how.

The perfect tax shelter
Most investors are intimately familiar with the tax rules that impose a maximum rate of 15% on capital gains and certain types of dividends. Although those rates were initially slated to expire at the end of last year, a last-minute law change extended the benefits of those lower rates through 2012.

But what many people don't realize is that there's an even lower rate on capital gains and qualified dividends that applies to taxpayers in the first two brackets. If you had taxable income of up to $68,000 in 2010 for married couples or $34,000 for singles, then part or all of your capital gains and dividends may be eligible for a 0% rate. That's right -- you may get to stiff the IRS entirely on a big piece of your investment income.

Now $68,000 isn't a huge number for some families, but remember that the number that's important is taxable income. That's the final number on which the IRS calculates your taxes, after applying all of your personal exemptions as well as your standard or itemized deductions. So your total income may actually be much higher while still allowing you to take advantage of the 0% rate.

Unfortunately, this doesn't give lower-bracket investors a free lunch on their entire income. You can only qualify for 0% treatment on the income that falls into those two lowest tax brackets. So once you have enough dividends or capital gains to push you above the $68,000 threshold, then you'll have to start paying taxes again at the 15% maximum rate. But for those with modest incomes, especially seniors who often live mostly from investment income, low rates give you an opportunity to take advantage of tax-free income.

Doubling up with dividends
One obvious way to use this opportunity is with dividend stocks. Their combination of steady income and growth potential makes investing in dividend-paying companies much more lucrative than other income-producing investments.

But with the 0% tax rate, dividend stocks let you double up on tax-free investing because you can use them to produce both dividend income and long-term capital gains. For instance, the following stocks share three traits you'd want to produce 0%-rate income: high yields of 3% or more, long-term dividend growth of at least 10% annually over the past five years, and share price appreciation of at least 10% per year since 2001.

Stock

Dividend Yield

Dividend Growth Rate

10-Year Annualized Return

ConocoPhillips (NYSE: COP  ) 3.4% 12.7% 14.4%
Royal Bank of Canada (NYSE: RY  ) 3.5% 11.1% 18.9%
McDonald's (NYSE: MCD  ) 3.3% 27.5% 12.3%
Southern Copper (NYSE: SCCO  ) 5.5% 11.7% 41.4%
Reynolds American (NYSE: RAI  ) 6.2% 28.5% 16.3%
Nucor (NYSE: NUE  ) 3.1% 36.9% 18.4%
Microchip Technology (Nasdaq: MCHP  ) 3.7% 24.9% 11.6%

Source: Capital IQ, a division of Standard and Poor's.

Of course, you can't necessarily expect to see the same explosive growth from these stocks in the next 10 years. But with a long history of solid payouts and dividend growth, you can at least count on them to produce income that's potentially eligible for tax-free treatment.

Get ready to save
With just seven weeks to go until the filing deadline, you can't do anything at this point to make the most of the 0% rate for your 2010 return -- you'll either qualify for it or you won't. But going forward, being aware of the tax rule that gives you tax-free treatment will remind you to take full advantage of it this year and next.

For more on getting your taxes in tip-top shape, you'll want to check out the Fool's Tax Center.

Be sure to tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger loves showing the IRS who's boss. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Nucor, which is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. You'll never find the Fool's disclosure policy taxing.


Read/Post Comments (9) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 28, 2011, at 5:19 PM, hbofbyu wrote:

    Wow. What a misleading headline.

    I don't see how "these stocks" stiff the IRS any more than "those" stocks or anyone elses stocks.

  • Report this Comment On February 28, 2011, at 8:50 PM, DelKlingon wrote:

    These misleading headlines are getting tiresome. It causes me (and I'm sure a lot of other Fools) to question the validity of what I'm reading. Before I clicked the link I was wondering if I was going to be disappointed by the article.

    Truth is, I like the article. Since I'm one of the under $68,000 MFJ crowd, this verifies what I already figured out doing my taxes last week.

    But as hbofbyu already pointed out, there's nothing special about "these" stocks. The headline makes one believe (before reading) that there are some mystical stocks out there that are so different, they "Stiff the IRS".

    You don't need to insult our intelligence with these ridiculous headlines. I read almost every article anyway, especially Dan's.

  • Report this Comment On March 01, 2011, at 1:06 AM, Rowants wrote:

    How about HGG? Down 25% since being recommended. Not only do you not pay any tax, but when you sell for a loss, you can offset something that actually made money.

  • Report this Comment On March 01, 2011, at 2:20 AM, PoundMutt wrote:

    Can't you block those sales adds?

  • Report this Comment On March 01, 2011, at 3:09 AM, Latinus wrote:

    Ditto PoundMutt

  • Report this Comment On March 01, 2011, at 7:43 AM, TMFGalagan wrote:

    @hbofbyu, DelKlingon -

    What's special about these particular stocks is that they let you benefit from the 0% tax rate in two different yet very significant ways. They're a good place to start for those who don't already have ideas about where they might want to invest. But you're right that if you have your own dividend stocks with growth potential that you're interested in, then they would also let you take maximum advantage of the 0% rate.

    best,

    dan (TMF Galagan)

  • Report this Comment On March 01, 2011, at 10:39 AM, gwgw10 wrote:

    I wonder if that tax break applies to the with-holding tax on RY (25% with-holding tax I believe)

  • Report this Comment On March 01, 2011, at 12:19 PM, mikecart1 wrote:

    These headlines should be illegal. If newspapers wrote articles like this, they'd be getting sued all the time.

    "Girl Goes Missing For Days"

    And the article is about a girl that is home sick and missing the basketball team practice.

  • Report this Comment On March 01, 2011, at 8:32 PM, vidar712 wrote:

    At first I thought that this article was going to be about MLP's. You never have to pay taxes on them if you don't sell before you die.

    @mikecart1

    You are right. Newpapers set the standard for literary excellence. I especially enjoy the headline "Dewey Defeats Truman".

    Dewey must be our least noteworthy president in history. There was no mention of him in my Civics textbook.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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