Saturday, October 30, 2010

Converting Capital Gains to Ordinary Income

As I noted in my Converting Ordinary Income to Capital Gains posting, one neat trick that you can do, if you are in a high tax bracket, is to use depreciation deductions to reduce your income - offsetting ordinary income by the depreciation deduction allowed on a rental property, for example.

It is a neat trick, as it defers the taxation to a later date (when you sell the property and pay the capital gains tax) and it also may knock you into a lower bracket.  So you might end up taking an effective tax rate of 50% or more (with Federal , State, and self-employment taxes) and knocking it down to a 15% to 25% capital gains rate.

But note that the opposite is also true, and it is true using one of the mechanisms that we have been told is the greatest tax dodge for the middle class - the IRA or tax-deferred retirement account.  In these accounts, you pay in money during your working years, and that money is not taxed when contributed.

When you retire, you withdraw money from your IRA or other tax-deferred account and then pay taxes on the amount withdrawn.  The idea is, your tax rate at that point will be lower than when you were working.

However, all the money is taxed as "ordinary income" - the portion of the IRA money that is your contribution (ordinary income that was not taxed originally), dividends (from stocks in the mutual funds you were invested in) as well as capital gains (increase in value of the stocks you may have been invested in).  So while capital gains might be taxed at 15% at the time of this writing, if you retire in the 25% tax bracket, arguably you may be paying more money in taxes, to some extent, on that portion of your IRA withdrawal.

To some extent this is necessary, as trying to parse which part of your IRA withdrawal is ordinary income and which is capital gains would be an accounting nightmare.  So it is all taxed at your ordinary income rate.  Since most people retire in a lower tax bracket than they earned in, it is not a bad deal - you still save a lot on taxes.

And since the taxes are deferred, you earn much more on your investment than you otherwise would in an after-tax investment.

Perhaps the only time this might not apply is if you retire in a high tax bracket, and make an investment in your IRA right before retirement that has a huge capital gain.  For example, you invest $10,000 in ACME stock at age 50, which doubles in value the next year.  You get $10,000 knocked off your income when you make the contribution.  But that $10,000 gain will be taxed at your ordinary income rate, say 25%, when you withdraw it.  But a similar gain, at ordinary capital gains rate (long-term) would be taxed at 15% if it was not in your IRA.

Granted, this is an extreme and unusual example, and overall the tax savings of contributing to an IRA or other tax-deferred savings account are significant.  Moreover, you should be saving in any regard, as it is the only way to accumulate wealth.

But it does illustrate that you can convert capital gains into ordinary income!

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