The Internal Revenue Code is a very complex and often confusing set of
rules. Sometimes individuals let tax issues cloud their decision-making. Here
are three areas where some simple reminders can help you make wiser financial
decisions:
The income tax rate structure
Our marginal tax rate structure generally means that income at lower levels
is taxed at lower rates than income at higher levels. There are complex rules
about how to calculate taxable income, taking into account deductions and
exemptions. The 2001 tax law started to bring rates down and the 2003 tax law
change accelerated that reduction. The tax rates start at 10% and go up to
35%. Below is the married filing jointly tax table for 2004.
Married Filing Jointly Rate Schedule
| Taxable income levels |
Tax rate |
| 0 to $14,300 |
10% |
| $14,301 to $58,100 |
15% |
| $58,1011 to $117,250 |
25% |
| $1117,251 to $178,650 |
28% |
| $178,651 to $319,100 |
33% |
| Over $319,100 |
35% |
Taxes on capital gains and dividends compared to regular
taxes
Gains on the sale of most investments held more than one year usually
receive favorable tax treatment. The top tax rate for most long-term capital
gains is now 15% (for transactions after 5/5/03), compared with a top tax
rate of 35% on other income for 2003. If you are considering selling a stock
at a gain that you have held for almost 12 months, consider waiting for the
full 12-month period to lapse. But remember, waiting means you are still
subject to market fluctuations.
Under the 2003 Tax Act, most dividends from investments will now be taxed
at the same rates as capital gains. For individuals with relatively large
amounts of dividend income, this could represent a significant tax
reduction.
Taxable vs. tax free bonds
Those in higher tax brackets often benefit from tax-exempt interest
income. To see if you should consider tax-exempt bonds, compare the after tax
yield of a taxable bond to the yield of a tax-exempt bond. To calculate the
after tax yield of a taxable bond you can use the following formula:
For example, here is the equation to calculate the after tax yield of a
taxable bond with a yield of 6% for someone in the 35% marginal tax bracket.
AFTER TAX YIELD = 6% - (6% X .35)
&n
bsp; &nbs
p; = 6% - (2.1%)
&n
bsp; &nbs
p; = 3.9%
Or, you can use the following table:
| Tax exempt yield |
Equivalent taxable yields in
these marginal tax brackets |
|
15% |
25% |
28% |
33% |
35% |
3.0% |
3.5 |
4.0 |
4.2 |
4.5 |
4.6 |
3.5% |
4.1 |
4.7 |
4.9 |
5.3 |
5.4 |
4.0% |
4.7 |
5.3 |
5.6 |
6.0 |
6.2 |
4.5% |
5.3 |
6.0 |
6.3 |
6.8 |
6.9 |
5.0% |
5.9 |
6.7 |
6.9 |
7.5 |
7.7 |
5.5% |
6.5 |
7.3 |
7.6 |
8.3 |
8.5 |
The tax brackets are those in effect in 2004.
Remember, to get a true comparison it is critical that the taxable and tax
exempt bonds have similar maturity dates and similar quality ratings.
According to the chart, a tax-exempt bond yielding 4.0% has an equivalent
after-tax yield of 6.0% for someone in the 33% tax bracket. For that person,
a taxable bond yielding more than 6.0% will produce a better after tax
return.
Final Words
Taking time to understand how the tax laws apply to your financial
situation will enable you to make more informed decisions. You should always
consult your tax advisor to determine how the rules apply to your situation
and remember that state income taxes must be considered.
