Dear Tax Talk,
I’m a middle-class investor just trying to save for the usual things later in life — home, kids’ college, retirement, etc. If I understand the law correctly, I can sell my $120,000 in mutual funds in 2008 and not pay any capital gains tax on that. Am I correct? This is too good to be true. What are the limiting factors for this great deal? Thanks. — Fred


Dear Fred,
It must be a dream. In 2008, the government is having a close-out sale on capital gains. Plan now to save big.

In 2003, George Bush cut the capital gains rates from 20 percent to 15 percent and, for certain lower-income taxpayers, the rate went from 15 percent to 5 percent.

The rate on qualifying dividends was also cut to 15 percent and 5 percent. Qualifying dividends are generally dividends paid from a corporation that has previously paid income tax on the earnings distributed. A mutual fund may return some or all qualifying dividends.

But in order to get the 5-percent rate you have to be in the 10-percent tax bracket on your other types of income and within the 15-percent bracket overall. If you go above these limits, the income in excess of the limits is taxed at the 15-percent rate. However, you still get the lower rates on the income within the limits.

In 2008, the 5-percent rate becomes zero, unless something changes in the interim. In order to qualify for the 5-percent or zero-percent rates in 2008, your taxable income, including the capital gains and qualifying dividends, has to be below the level on which you would pay tax at the 25-percent rate, ignoring the fact that your income is capital gains.

In 2003, the 25-percent rate kicked in at taxable income greater than $56,800 for a married couple and $28,400 for a single taxpayer. These levels are adjusted annually for inflation; for 2004, the 25-percent rate kicks in at taxable income greater than $58,100 for a married couple and $29,050 for a single taxpayer. Of course, the tax law is always changing.

This means that if in 2003 your income consisted solely of capital gains and qualifying dividends, you would have paid tax at 5 percent on income up to $72,400 (taking into account the standard deduction of $9,500 and $6,100 for two exemptions).

Forgetting inflation adjustments and law changes, the tax in 2008 on this amount of income would be zero. If you had other types of income in 2008, you would still get some benefit of the zero tax rate, provided there isn’t so much other income that it takes you out of the 10-percent tax bracket.