The Tax Implications of
Financial Decisions

The Tax Implications of Financial Decisions

The Internal Revenue Code is a very complex, often confusing, and constantly changing set of rules. Individuals sometimes 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 accelerated that reduction. The tax rates start at 10% and go up to 35%.

 

  
2010 Single Return Rate Schedule
Taxable income levels Tax rate
0 to $8,375 10%
$8,376 to $34,000 15%
$34,401 to $82,400 25%
$82,401 to $171,850 28%
$171,581 to $373,650 33%
Over $373,650 35%

 

  
2010 Married Filing Jointly Rate Schedule
Taxable income levels Tax rate
0 to $16,750 10%
$16,751 to $68,000 15%
$68,001 to $137,300 25%
$137,301 to $209,250 28%
$209,251 to $373,650 33%
Over $373,650 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%, compared with a top tax rate of 35% on other income for 2010. 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. Be sure the bonds have similar maturity dates and similar quality ratings. This chart can help with that comparison.

 

    
Equivalent taxable yield in these 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 2010.

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. Taking time to understand how the tax laws apply to your financial situation will enable you to make more-informed decisions.

Note: 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.

 

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