More ways to earn tax-free income / 4 other instances when Uncle Sam (the IRS) doesn’t get a cut

Bill Bischoff for MarketWatch writes: There are still ways to earn income that is federal-income-tax-free. With the tax increases that took effect at the beginning of this year, opportunities to collect tax-free income are more valuable than ever. This story is the second of our two-part series on some of the best ones. (For the first installment, see How to earn tax-free income (really).)

Tax-Free Section 529 Accounts

The biggest advantage of 529 college savings plans is they are allowed to accumulate earnings free of any federal income tax. When the account beneficiary (typically your child or grandchild) reaches college age, tax-free withdrawals can be taken to cover higher education expenses. State income tax breaks are often available too.

Contributions to a 529 account will also reduce your taxable estate (if you’re worried about that), because they are treated as gifts to the account beneficiary. Contributions in 2013 are eligible for the $14,000 annual federal gift tax exclusion. Contributions up to that amount won’t diminish your unified federal gift and estate tax exemption ($5.25 million for 2013). If you’re feeling really generous, you can make a larger lump-sum contribution and spread it over five years for gift tax purposes. That allows you to immediately benefit from five years’ worth of annual gift tax exclusions while jump starting the beneficiary’s college fund.

Example: If you’re unmarried, you can make a 2013 lump-sum contribution of up to $70,000 (5 x $14,000) to a Section 529 account set up for a child, grandchild or any other person you want to help. If you’re married, you and your spouse can together contribute up to $140,000 (2 x $70,000). Lump-sum contributions up to these amounts won’t diminish your $5.25 million unified federal gift and estate tax exemption. If you want to help several children or grandchildren, you can run the 529 account contribution drill for each one.

Tax-Free Coverdell Education Savings Accounts

If you’re not such a high roller, you have the option of contributing up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary (typically your child or grandchild) who hasn't yet reached age 18. A CESA is an account set up by a “responsible person,” which means you, to function exclusively as an education savings vehicle for the designated account beneficiary.

CESA earnings are allowed to accumulate federal-income-tax-free. Then tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.

Here’s the only catch: your right to make CESA contributions is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 or between $190,000 and $220,000 if you’re a married joint filer. This restriction can often be circumvented by enlisting someone who is unaffected. For example, you can give the contribution dollars to another trustworthy adult who can open up the CESA as the “responsible person” and make the contribution on behalf of your beneficiary. However, when the “responsible person” is someone other than yourself, you lose any control over the account. Keep that in mind.

Tax-Free Capital Gains and Dividends

The federal income-tax rate on long-term capital gains and qualified dividends is still 0% when they fall within the 10% or 15% tax brackets. In fact, the 0% rate is now permanent rather than temporary (until further notice). The surprising truth is you can have a healthy income and still be within the 15% bracket and thus eligible for the 0% rate on some or all of your long-term gains and dividends.

• Say you’re a married joint filer with two dependent kids. You claim the standard deduction. For 2013, you could have up to $100,300 of adjusted gross income—including long-term gains and dividends—and still be within the 15% rate bracket.
• Say you are divorced and file as a head of household. You have two dependent kids and claim the standard deduction. For 2013, you could have up to $69,250 of adjusted gross income—including long-term gains and dividends—and still be within the 15% bracket.
• Say you are unmarried with no kids. You claim the standard deduction. For 2013, you could have up to $46,250 of adjusted gross income—including long-term gains and dividends—and still be within the 15% bracket.
  • If you itemize deductions, your adjusted gross income—including capital gains and dividends—could be even higher, and your taxable income would still be within the 15% bracket.
  Tax-Free Small Business Stock Gains
  Qualified Small Business Corporations (QSBCs) are a special category of corporation, the stock of which can potentially qualify for gain exclusion breaks. The hot news is that QSBC shares issued between now and year-end are eligible for a juicy 100% gain exclusion if you hold shares for over five years before selling. Here’s the abbreviated story on tax-favored QSBC stock.
  General 50% Exclusion:
  Under the general gain exclusion rule, QSBC shareholders are potentially eligible to exclude from taxation up to 50% of their gains on sale of QSBC stock.
  Special 100% Exclusion:
  Recent legislation created an unbeatable 100% gain exclusion for sales of QSBC shares issued between 9/28/10 and 12/31/13. That translates into a 0% federal income-tax rate on gains when QSBC shares are sold down the road.
  Key Point: The gain exclusion percentage is scheduled to drop back to the normal 50% level for shares issued after this year.
  More-Than-Five-Year Holding Period Requirement:
  The gain exclusion breaks are only allowed for QSBC stock that you’ve held for more than five years. Consult your tax pro if you’re considering a stock investment that might be eligible for the QSBC gain exclusion deal.