Bob and Carolyn have been retired for ten years. When Bob retired he had accumulated a comfortable nest egg of $1.8 million dollars. A third of his savings was in the common stock of his employer. The company 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. Bob began to take the dividends in cash when he retired to supplement his income.
Bob and Carolyn are now in their mid-70s. Earlier this year I did an evaluation of 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 fixed income. Bob still had $500,000 invested in the company stock that was divided between the 401(k) and the taxable accounts.
The company stock had done poorly since his retirement but Bob refused to sell it because he hated paying capital gains tax. The stock had a low cost basis from 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 they could see the entire nest egg wiped out in 10 years. Fortunately there is an answer that will help even Bob who hates to pay capital gains tax.
The 0% tax rate on long-term capital gains applies to taxable income up to $35,350 for single taxpayers. The threshold is $70,700 for married couples filing jointly in 2012. This number refers to the net taxable income after itemized deductions. Thus a joint filer with an AGI of $100,000 may still be able to take advantage of the 0% bracket if they have itemized deductions of $29,300. That level is not difficult to reach if you live in a state that has a high income tax, hold a home mortgage, or are charitably minded.
Additionally you could exceed the taxable income and still receive a partial benefit from the 0% bracket because the portion of your capital gain that is below the threshold would still qualify for the 0% rate. For example, a joint filer with $40,000 in long-term capital gains and $40,000 in other income after deductions would have $30,000 of the gain taxed at zero and $10,000 taxed at 15%.
Social Security Warning
Retirees drawing social security benefits need to take care in determining the amount of capital gains they can realize and stay in the 0% bracket. Review my newsletters on social security taxation to familiarize yourself with the calculation used to tax benefits. Capital gains is income that is used to determine how much of your social security gets taxed. Realizing an additional $10,000 in capital gains could make $5,000 more of your social security subject to tax and potentially put you over the 0% bracket.
Tax savings is only one reason for taking gains. Other reasons to consider:
- 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.
- Concentrated positions – 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 single position.
- Establishing a new cost basis – Sell 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.
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 reduces their taxable ordinary income allowing more stock to be sold at the 0% capital gains rate. Selling the stock in the 401(k) has no tax implications. The proceeds can be used to buy fixed income assets maintaining 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 will be sold in thirds in 2012–2014. Bob will still have to pay capital gains tax on some of the sales proceeds but he is learning to appreciate the wisdom of evaluating performance on an after-tax basis.
Keep in mind that the 0% tax rate is currently only scheduled to last through the end of 2012. You should begin implementing your 0% bracket strategies as soon as possible. Congress may or may not extend the law in 2013.
- The 0% tax bracket for long term capital gains is available until the end of 2012.
- 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.
- Be careful if you receive Social Security benefits when taking gains. The gains may be taxed at zero but they could make more of your benefits subject to tax.