Bob and Carolyn have been retired for ten years. When Bob retired, he had accumulated a comfortable nest egg of $1.8 million. His employer had an employee stock purchase program allowing him to invest through payroll deduction. The stock had done well over the years, paying cash and stock dividends that Bob reinvested while he was working. A third of his savings was now in a single common stock. Bob had begun to take the dividends in cash to supplement his income.
Today, Bob and Carolyn are in their mid-70s. Earlier this year, I evaluated their investment portfolio and found that it was still worth $1.8 million. One-third of it was invested in three rental properties, another third was still in the company 401(k) plan and the remaining third was invested in various stocks, mutual funds, and bonds. Bob still had $500,000 invested in the company stock that was divided between the 401(k) and the after-tax accounts.
The company stock had done poorly since his retirement, but Bob refused to sell it because he hated paying capital gains taxes. The low-cost basis in the stock was a result of many years of accumulation and reinvested dividends. Bob thought he was being savvy by keeping the stock and not paying capital gains tax. The reality is the purchasing power of his nest egg had shrunk to $1.3 million because of inflation. Allowing this to continue would eventually reduce Bob and Carolyn’s standard of living. If one or both of them ended up in a nursing home their entire nest egg could be wiped out. Fortunately, there is a solution that could help even Bob who hates to pay capital gains tax. The 0% tax rate on long-term capital gains!
Long-term capital gains are taxed at a lower rate than other types of income based on a taxpayer’s taxable income.
|Long-term Capital Gains Tax Rate||Single Filers (taxable income)||Married Filing Jointly||Heads of Household||Married Filing Separately|
|20%||Over $441,450||Over $496,050||Over $469,050||Over $248,300|
Keep in mind that taxable income is the amount after itemized deductions or the standard deduction. Thus, a joint filer with an adjusted gross income of $104,800 will still be able to take advantage of the 0% bracket because the standard deduction in 2020 is $24,800.
A taxpayer could exceed the taxable income threshold and still receive a partial benefit from the 0% bracket because the portion of a capital gain that is below the threshold would still qualify for the 0% rate. For example, a joint filer with $50,000 in long-term capital gains and $50,000 of other income after deductions would have $30,000 of the gain taxed at zero and $20,000 taxed at 15%.
Social Security Warning
Retirees drawing Social Security benefits need to be careful when determining the amount of capital gains they can realize and stay in the 0% bracket. Review our newsletters on Social Security taxation to familiarize yourself with the calculation used to tax benefits. Capital gains income is used to determine how much of a taxpayer’s Social Security benefit will be taxed. Realizing an additional $10,000 in capital gains could make as much as $5,000 more of Social Security benefits taxable.
Tax savings in the 0% tax bracket are only one reason for taking capital gains. Other considerations are:
The need to raise cash or to rebalance a portfolio
Rebalancing a portfolio is always a challenge with a taxable account. Usually, we rebalance in tax-deferred accounts to minimize tax implications. Lower bracket taxpayers can utilize the 0% rate to rebalance taxable accounts.
Some investors hold a significant portion of their wealth in one low-basis asset. They may be able to take low-taxed gains and use the proceeds to diversify and reduce exposure to a single position.
Establishing a new cost basis
Consider selling your appreciated securities to realize the gain when you know it will be taxed at zero and then immediately buy it back. You don’t have to worry about wash sale rules because they only apply to taking capital losses.
State Income Taxes
Taxpayers living in states that tax capital gains need to remember they may pay state income tax on capital gains, even if the federal tax rate is 0%.
Help for Bob & Carolyn
My strategy for Bob and Carolyn was to reposition the portfolio to place most of the income-producing assets into their tax-deferred accounts. This reduced their taxable ordinary income, allowing more stock to be sold at the 0% capital gains rate. Selling stock in the 401(k) had no tax implications. The proceeds were used to buy fixed-income assets and maintain a balanced investment strategy. Bob wanted to keep $100,000 in the stock for sentimental reasons. The balance of the stock in their taxable account would be sold in thirds over the next three years. Bob will still have to pay capital gains tax on some of the sale proceeds, but he is learning to appreciate the wisdom of evaluating performance on an after-tax basis.
Keep in mind that the current tax rates are set to expire in 2025. The future of tax rates on long-term capital gains is uncertain. Taxpayers should consider taking advantage of the 0% bracket strategy while it is still available.
- The 0% tax bracket for long term capital gains is available based on net taxable income.
- Wash sale rules apply only to capital losses. Consider establishing a new cost basis for appreciated securities that can be sold in the 0% bracket.
- Social Security recipients need to evaluate the tax impact on benefits when taking capital gains.