Wednesday, February 8, 2012

Think you pay 15% on your Long Term Capital Gains? Pffftttt, think again.

Mitt Romney's disclosure of his massive income and sub 15% federal income tax rate has opened eyes to the inequity in our income tax code.  How did Mitt pay so little in income taxes?  The 15% tax on LT Capital Gains helped.  That,  teamed with having most of his income classified as "carried interest" which gets the 15% LT Capital Gain tax treatment. But about that 15% rate,  it doesn't apply to you. It's not for minions. It's only reserved for the super-rich, like Mitt.  The LT Capital Gain rate you pay is likely 40% higher than what Mitt pays.  Don't believe me?  Read on.

Let's just cut to the chase.  If you have appreciable LT Cap Gains,  and your taxable income is between $150 and $464 K,  then it's highly likely that you are caught in Alternative Minimum Tax (AMT) hell.  And that's where the lies about the 15% tax on LT Capital Gains begin.  If you're in AMT,  you're paying 21-22% on your LT Capital Gains.  Yes,  I know,  you'll read in IRS literature that the 15% rate applies in AMT.  And it's also likely that you'll find more than a few naive CPAs around who will advise the same.  But that's just not the case.

The culprit is the AMT exemption.  It acts as a credit that reduces the AMT tax owed.  But,  if you're married filing a joint return,  for example,  your $72,450 exemption starts phasing out once your income exceeds $150 K.  For every dollar of income,  you lose 25 cents of the exemption.  It's the increase in taxes by virtue of losing a portion of this exemption that causes the tax on your LT Cap Gains to rise above the 15% rate.  In other words,  by having those LT Cap Gains,  you're losing some of the exemption, and that causes your AMT tax to rise.  The math is more clearly explained here. And there's more information here about the exemption amounts and where the phase-outs start,  based on your filing status.

And if you still don't believe me,  then there's an easy way to test it.  Plug your return into TurboxTax.  Override and change the LT Cap Gains number and watch how it impacts the tax you owe.  If your income is between $150 and $464 K,  and you're in AMT,  then you're going to find that changing your LT Gains by $1,000 causes your tax bill to ramp by about $220.

The bottom line is this,  you can find yourself in a situation where both you and Mitt own stock in Apple.  You both bought and sold the stock at the same time,  recognizing the very same gains on each share sold.  Although your total taxable income is but a very small fraction of Mitt's,  your federal income tax on that Apple gain is 40% higher than what the super rich Mitt Romney had to pay.   Direct your thank you notes for this inequitable situation to your representatives in Congress.

There's a trade to be made here though.  It's likely that our tax rates will change appreciably in 2013.  Capital Gains tax will likely go up and investors left and right will rush the exit at YE 2012 to lock in the supposed 15% rate.  That forced selling should send the market lower.  And it will be an excellent time to buy.

But here's the important point.  Don't be a sucker and necessarily join the crowd in the selling spree.  Chances are good that the Cap Gains rates will only be raised to 20%.  And as this article indicates,  that would actually represent a tax cut for many,  especially if other changes wind up reducing the impact of AMT.   So,  pay close attention to your own personal tax situation,  and the change made not only to LT Cap Gains rates,  but also to how AMT is determined.

Why is this situation so unfair?  Well,  look at the statistics of who gets trapped in AMT.   Spend 5 minutes looking at this excel spreadsheet of data (latest release 2008) from the IRS.  Here are the stunning facts about how AMT winds up screwing the middle class,  to the benefit of the super-wealthy:

Bottom Line? The vast majority of AMT tax is paid by Americans with income between $200 - $500 K. And the vast majority of that arises from the 21-22% tax rates slapped on Capital Gains while in AMT. Meanwhile, the super-wealthy slide by,  paying little in AMT and only 15% on their LT Cap Gains.

Like I said, send your thank you notes to Congress. I'm only the message delivery boy. My message should be clear though ... You're getting screwed. And the Mitt Romney's of the world are laughing all the way to the bank.

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