45. How Income is Normally Taxed

Before the imposition of the income tax, a dollar of income was worth a dollar. Today, this is not always so--it depends on what tax bracket you are in and whether the income is tax free, ordinary income, or capital gain. Therefore, while the initial amounts of income of different individuals may be equal, some types of income are more equal than others, giving some of our hypothetical individuals more after-tax spendable
income.

The United States income tax system consists of a graduated series of tax rates. "Ordinary" income is taxes at a progressively higher rate as the taxpayer climbs the income scale. The term "ordinary" income
encompasses personal service or earned income, as well as income derived from interest, dividends, rents, and royalties. The maximum tax rate on ordinary income is 50%. It is when income approaches the higher tax rates
that the need for a tax shelter becomes important.

Tax-Exempt Income

One of the best tax shelters available is provided by tax-exempt securities. Actually, this shelter is unique in that the entire income from tax-exempts is not subject to federal income tax at all. In addition, tax-exempt interest is not considered tax-preference income for purposes of the 15% minimum tax or the alternative minimum tax. This gives tax-exempt interest a big edge over other types of tax-sheltered income. For example, while the untaxed portion of capital gain is not considered tax-preference income for the 15% minimum tax, it is subject to the alternative minimum
tax.

In talking about tax-exempt municipals, we are using that term in the broadest sense to include bonds issued by state, county, city, and other local authorities. The interest on them is exempt from federal taxation. In addition, the interest is generally exempt from local taxation if the bonds are held by residents of the state in which they are issued. The
interest is taxable by local authorities, however, if the bonds are issued by a state or authority outside the state of residence of the holder, with one exception--interest on Puerto Rico bonds is not taxable in any state, regardless of the holder's residence.

The Capital Gain Tax Shelter

The most common and well-known tax shelter is that provided under the tax rules for capital gain. The gain realized on the sale of a capital asset is favorably taxed, providing that certain requirements are met. In general, since 60% of an individual's long-term capital gain may be deducted under IRC 1202, only 40% of his or her capital gain is taxed at
the regular tax rate.

Tax reference verification 1-800-829-1040

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