Capital gains - tax treatment

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Posts: 35
Joined: Wed Apr 20, 2016 6:06 pm

Re: Capital gains - tax treatment

Post by eric »

Thanks very much for your suggestions. I'll take a careful look and think this through.

I understand that the planning process is dominated by uncertainties and not by details like this. But in order to know what's important and what's not, I need to think it through carefully before I can disregard it. As an example, a 1% difference is not significant over a short term, but could easily be significant over 30 years (compounded). I appreciate your help.

If you have time, and interest, I'd be glad to know your reaction to my posting and discussion with jimr in another thread, regarding how to model tax-deductible expenses, and particularly mortgage interest - ... 2517#p2517
Posts: 13
Joined: Sat Apr 16, 2016 9:32 pm

Re: Capital gains - tax treatment

Post by trfrp »

eric wrote:15% looks suspiciously like the capital gains tax rate.
The most important point about the two tax rates in FRP is that they should be the average overall effective tax rate that YOU expect to experience in YOUR plan. It should not the top marginal rate that you are paying or expect to pay. Here are some thoughts on coming up with tax rates:
  • Relatively speaking, your ordinary Income Tax Rate in FRP is the easy part. Calculate your effective income tax rate by taking your total income taxes from your tax return and divide them by your gross income for the year.
  • Don't forget state income taxes! If you live in California, this can add several percentage points to your effective tax rate.
  • Calculating your income tax rate from the total numbers on your tax return may underestimate your effective ordinary income tax rate if you have significant dividends and capital gains that were taxed at the lower capital gains rate. Consider adjusting your rate accordingly.
  • The Investment Tax Rate in FRP is applied to all income from taxable savings, including interest, dividends, and capital gains. So the rate in FRP should be a blended rate to account for the fact that both ordinary and capital gains rates will be applied to these items.
  • Individuals typically pay federal income tax on dividends and capital gains at a capital gains rate of 15% to 20%. If the 20% rate applies to you, you'll have to come up with an estimate of the average rate that applies to all your dividends and capital gains. Again, don't forget state income taxes!
  • Watch out for AMT! If you are in AMT, for every dollar of additional income you earn you lose 25 cents of your AMT exemption. Assuming that you are subject to a 28% rate of AMT, the effective amount of tax on that extra dollar of income is really the tax on $1.25. Your overall effective tax rate computation from your tax return will already take this into account. So your FRP Income Tax Rate should be okay. But there is also an impact on your Investment Tax Rate that is harder to gauge. Assume you earn an extra dollar of dividend income taxed at the 20% capital gains rate. You will suffer an additional 7% of tax (28% * 0.25) on that dividend income, for a total marginal tax of 27%. There is no easy way to account for this. So I just add a few percent to my Investment Tax Rate in FRP to compensate for it.
  • Depending on your overall income, your Investment Tax Rate might also have to take into account the 3.8% Obamacare surtax on investment income.
There are obviously all manner of other factors that could materially impact your tax rates in FRP, not the least of which is future changes in the tax law. But as Jim pointed out, the results in FRP are not hugely sensitive to changes in the tax rates. So a reasonable ballpark estimate should be good enough. Based on the factors listed above, however, I concluded that the default tax rates in FRP were too low for my plan. Obviously, everyone's individual situation will differ.
Posts: 35
Joined: Wed Apr 20, 2016 6:06 pm

Re: Capital gains - tax treatment

Post by eric »

Thanks very much. A lot to think about!

AMT in particular is a mystery to me. I guess there's no choice but to dig into the tax regulations and figure it out.

I've done some sensitivity analysis, and discovered that tax rates are a significant factor in the success of my retirement plan. So even though I realize that the plan is based on some approximations and simplifications, I'll still need some more careful analysis of my tax rates to make sure I don't have any significant errors.
Posts: 1
Joined: Tue Jul 25, 2017 4:07 pm

Re: Capital gains - tax treatment

Post by sjb »

On other monte carlo analyzers like McRetire, the capital gains tax computation needs another input called tax basis for each type of account. For example it your taxable account taxable cost basis is 500,000 and current value is 1,000,000 and capital gains tax is 25% and the simulation takes out 10,000, then its assumed the tax basis is $5,000 and the tax owing is 25% x $5,000. The way the current system works it taxes any withdrawal even return of capital as a capital gain and over states the tax. Also, the ratio of tax basis to portfolio value will change dramatically over the life time of a retiree. The best solution is to have a tax basis % on every account at the start of the simulation and simulate it and its changes.
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