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.
Dividend Growth Rate
10-Year Annualized Return
Royal Bank of Canada
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.