If you itemize or even if you take the standard deduction, you probably want to consider the following: Too often I see people who have in essence paid more tax than they should have by not squeezing every bit of value out of their deductions.

To understand this concept, you need to understand the value of your deductions and the tax cost of income.

Long-term capital gains income: This type of income is taxed at a max rate presently of 15%.

Ordinary income: This type of income is taxed at your top marginal rate, but nearly always at a rate higher than your capital gains rate.

Short-term capital gains income: taxed at your ordinary income rate.

Capital losses: offset capital gains first, then are capped at $3000, i.e., the IRS is a fair weather partner participating in all gains, but only in immaterial losses. They do allow a carry forward of these losses because, in their eyes, it’s only fair.

Deductions and Exemptions: offsets against net taxable income (adjusted gross income or AGI).

Here’s the strategy:

Let’s say most of your income in a given year is relative to net long-term capital gains. Maybe you sold some real estate or a series of stops executed in your portfolio of highly appreciated stocks.

That means the bulk of your income is subject to a tax rate of 15%. Congratulations.

However, say it’s troubling you to think of paying a bigger tax bill than ever, so you start casting about to find more deductions. Perhaps you start thinking about giving more to charities that year to offset the big capital gain.

Stop, take a deep breath and think about what you’re doing. Here’s the central question:

Why use an ordinary income deduction that could offset at (up to) a marginal rate of 37% to overcome a 15% income item????

That would be the equivalent of paying a dollar-based debt in Euros right now without getting the benefit of the exchange differential.

What should you do if you’re in this situation? Take more out of your IRA or from an annuity with gain (ordinary income) to the extent that you have deductions and exemptions in excess of other ordinary income. This presumes you are older than 59 1/2 and not subject to the 10% penalty.

Believe me, I understand the panic mentality of facing capital gains and I have to approach the matter as a surgeon. It hurts, but let’s consider two things.

“First,” I say calmly to my clients, “It’s a GAIN for crying out loud! That is why we’re in this game in the first place, isn’t it? Would you rather be facing a loss? Back off from the wailing wall, would you?”

Secondly, after I’ve embarrassed them, I remind them that they aren’t likely to see capital gains at this rate for the next 20 years, so be thankful that the gains are happening now and not 2010.

Surgeons literally cut and make you bleed. I tend to humiliate with an impatient wit.

Both processes are designed to improve your life.   I’m not sure which one hurts more.

Tags: capital gains tax rates, federal tax deductions, income tax help, income tax questions, tax planning
Posted in BIG Blog, Finances, Guidance, Income Tax Management