Tax-Free Trick Many Ordinary Americans Don't Know About

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US Tax Day
Diane Macdonald
Many people believe that only rich people get the benefits of lucrative tax breaks. Yet for years now, the tax laws have made provisions for ordinary middle-class Americans to get just about the best possible tax break out there: tax-free treatment for a portion of their income. Even better, with this break, you don't have to lock up your money until retirement. In order to take advantage of this break, though, you have to know the specific types of income that are eligible -- and then put yourself in a position to start earning that kind of income for yourself.

Going Beyond Retirement Accounts

When most financial experts talk about tax-free growth, they'll typically mention Roth Individual Retirement Accounts and Roth 401(k) plan accounts. Roths give retirement savers a chance to earn tax-free income and growth on their investments, with the opportunity to avoid tax on all the gains they earn between when they make their Roth contributions and when they take the money out in retirement. Roths can make great investment vehicles for people saving for retirement, especially if you're in a low tax bracket right now.

But there's another tax-free opportunity that you don't need a retirement account to use. The tax law currently makes provisions for special treatment for two types of investment income: long-term capital gains and qualified dividends on stocks and mutual-fund distributions.

The part of these tax provisions that people know best applies to higher-income taxpayers. Until 2013, a maximum rate of 15 percent applied to long-term capital gains and qualified dividends. Two years ago, changing tax laws imposed a 20-percent rate on those taxpayers who were in the highest available tax bracket.

What many people never realize, though, is that a special 0 percent rate applies to taxpayers who are in the two lowest income-tax brackets. That might sound like it's reserved for low-income taxpayers, but in actuality, the second-lowest bracket extends upward all the way to taxable income of $73,800 for joint filers and $36,900 for single filers. Moreover, that doesn't include the standard or itemized deductions and personal exemptions that many people qualify to take, allowing you to make even more money while still remaining in those brackets.

How to Earn Tax-Free Income

If you're in one of those two lowest tax brackets, then tax-free treatment is yours for the taking. But that still leaves the question of what you need to do to earn the right type of income to qualify.

Long-term capital gains are relatively simple. If you have profits from an investment, you have to have held on to that investment for at least a year plus a day in order to get long-term treatment for the gains when you sell. Otherwise, higher short-term capital gains rates apply for investments held for a year or less.

For qualified dividends, the requirements are a little trickier. Typically, stock of U.S. corporations and of some foreign corporations whose shares are listed on a U.S. stock exchange will meet the test for qualified dividend treatment. But special entities like real-estate investment trusts, business development companies and master limited partnerships don't always qualify for the lower rate. In addition, to get qualified dividend treatment, you have to hold on to the stock for more than 60 days out of the four-month period surrounding the date on which the stock goes ex-dividend. Otherwise, you'll pay the ordinary income tax rate for regular income.

If you hold stocks through a mutual fund, then part of the distributions you receive from the fund will represent qualified dividends. Under some circumstances, a fund might pay out some qualified and some nonqualified dividend income, but in that event, it will report that fact on the 1099 tax document you receive early in the year.

From a big-picture standpoint, the tax-free provisions of the tax laws act as an incentive for those with modest income levels to invest for the long run, especially in the stock market. Given the lengths to which most people would go to avoid having to pay tax on their income, making the most of long-term capital gains and qualified dividends makes a lot of sense -- and not only will it save you on your taxes, but it might just encourage you to invest more profitably as well.

Motley Fool contributor Dan Caplinger always looks for tax-saving tricks. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.
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