by Archie M. Richards, Jr., CFP^®
December 10, 2001

Misconceptions about taxes shared by many Americans are described in What the IRS Doesn't Want You to Know, by Martin S. Kaplan, CPA, and Naomi Weiss. Here are some of the misunderstandings:

If I'm in the 30.5-percent tax bracket, this means that 30.5 percent of my taxable income is taxed. No, only the last dollar of your income is taxed at 30.5 percent. Let's say you file a joint federal return and your taxable income, after deductions, totals $120,000:

• The first $45,200 is taxed at only 15 percent.
• The next $64,050 is taxed at 27.5 percent.
• The final $10,750 is taxed at 30.5 percent.
• The tax amounts to $27,673. This is 23.1 percent of $120,000, not 30.5 percent.

When I move money from one mutual fund to another within the same family of funds, I don't have to worry about paying the capital gains tax. Yes, I'm afraid you do. The sale of any mutual fund triggers the tax, even if the money goes from one fund to another within the same fund family. (A "fund family" is a group of mutual funds offered by the same organization, such as TIAA-CREF or Vanguard.)

Municipal bonds are completely tax free. The interest is federally tax free, true. But when it's paid off at maturity or if you sell it before maturity, any gain between the cost you paid and the proceeds you receive is taxable. Also, most states tax the income from the municipal bonds of other states.

A stock I own split 3-for-2. How much tax will I owe? None. You pay tax only when the shares are sold. Let's say you bought 200 shares for $6,000. Your cost was $30 per share ($6,000 divided by 200 shares). The stock splits 3-for-2. You then own 300 shares (3/2 times the original 200 shares). Your new cost per share is $20 (2/3rds the original $30 price). If you later sell the stock for $25 a share, you pay capital gains tax on $5 a share ($25 less $20).

If I receive an inheritance from Aunt Agatha, what portion will the IRS take? It won't take any. Inheritances are free from federal income tax. But if you inherit a retirement plan, such as a traditional IRA or a 401(k) Plan, you would have to pay tax on the withdrawals. Aunt Agatha had to pay tax on the money she withdrew from the plan, but she died before withdrawing the money completely. The withdrawals you make are therefore taxable to you.

If I pay out money from my traditional or Roth IRA before age 59 ½, I must pay a 10-percent penalty. That depends. If you use the money for medical purposes, education, buying a house, or for certain other purposes, the penalty is excused. Otherwise, you pay the 10-percent penalty, which is not deductible. The exact rules are explained in IRS Publication 590, which you can download from www.irs.gov. (Click on "Forms and Publications" at the bottom of the Web page.)

If I submit an application for Automatic Extension of Time to file my income tax, I can delay the tax payment until the return is finally filed. If this were so, all of us would apply for extensions. No, the tax is due on April 15, even if you file the return later. You probably won't know the exact amount by April 15. Just give it your best shot.

I sold my house at a loss. I can use the loss to offset capital gains on stocks. Sorry. Houses are considered to be "personal property." Losses from the sales of personal property cannot be deducted at all.

My husband died and left me his company retirement plan. I should request a lump sum and take control of the money, right? This probably wouldn't be a good idea. The entire amount would become taxable in that year, possibly lifting your income into a higher tax bracket. You'd be better off transferring the money to a traditional IRA. Such a transfer is called a "rollover," and it's tax free. Talk with a tax advisor about converting all or part of this money to a Roth IRA.