When you sell a stock, mutual fund, investment property, or a business, if you have made money on that investment, the IRS is kindly waiting for a piece of that gain in the form of capital gains tax. Capital gains are taxed differently than the ordinary income that you received via your paycheck or pass-through income from your business. Unlike ordinary income, which has a series of tax brackets that range from 10% to 37% in 2018, capital gains income is taxed at a flat rate at the federal level. Most taxpayers are aware of the 15% long term capital gains tax rate but very few know about the 0% capital gains tax rate and how to properly time the sale of your invest to escape having to pay tax on the gain.
Short-term vs Long-Term Gains
Before I get into this tax strategy, you first have to understand the difference between “short-term” and “long-term” capital gains. Short-term capital gains apply to any investment that you bought and sold in less than a 12 month period. Example, if I buy a stock today for $1,000 and I sell it three months later for $3,000, I would have a $2,000 short-term capital gain. Short-term capital gains are taxed as ordinary income like your paycheck. There is no special tax treatment for short-term capital gains and the 0% tax strategy does not apply.
Long-term capital gains on the other hand are for investments that you bought and then sold more than 12 months later. When I say “investments” I’m using that in broad terms. It could be a business, investment property, stock, etc. When you sell these investments at a gain and you have satisfied the 1 year holding period, you receive the benefit of paying tax on the gain at the preferential “long-term capital gains rate”.
What Are The Long Term Capital Gains Rates?
For federal tax purposes, there are 3 long term capital gains rates: 0%, 15%, and 20%. What rate you pay is determined by your filing status and your level of taxable income in the year that you sold the investment subject to the long term capital gains tax. For 2018, below are the capital gains brackets for single filers and joint filers.
As you will see on the chart, if you are a single filer and your taxable income is below $38,600 or a joint filer with taxable income below $77,200, all or a portion of your long term capital gains income may qualify for the federal 0% capital gains rate.
An important note about state taxes on capital gains income is that each state has a different way of handling capital gains income. New York state is a “no mercy state” meaning they do not offer a special tax rate for long term capital gains. For NYS income tax purposes, your long term capital gains are taxed as ordinary income. But let’s continue our story with the fed tax rules which are typically the lion share of the tax liability.
In a straight forward example, assume I live in NYS, am married, and my total taxable income for the year is $50,000. If I realize $25,000 in long term capital gains, I will not pay any federal tax on the $25,000 in capital gain income but I will have to pay NYS income tax on the $25,000.
Don’t Stop Reading This Article If Your Taxable Income Is Above The Thresholds
For many taxpayers, their income is well above these income thresholds. But I have good news, with some maneuvering, there are legit strategies that may allow you to take advantage of the 0% long term capital gains tax rate even if your taxable income is above the $38,600 single filer and $77,200 joint filer thresholds. I will include multiple examples below as to how our high net worth clients are able to access the 0% long term capital gains rate but I first have to build the foundation as to how it all works.
Using 401(k) Contributions To Lower Your Taxable Income
In years that you will have long term capital gains, you should find ways to reduce your taxable income to get under the 0% thresholds. Here is an example, I had a client sell a rental property this year and the sale triggered a long term capital gain for $40,000. They were married and had a joint taxable income of approximately $120,000 before deductions. If they did nothing, at the federal level they would just have to pay the 15% long term capital gains tax which results in a $6,000 tax liability. Instead, we implemented the following strategy to move the $40,000 of capital gains into the 0% tax rate.
Once they received the sale proceeds from the house, we had them deposit that money to their checking account, and then go to their employer and instruct them to max out their 401(k) pre-tax contributions for the remainder of the year. Since they were both over 50, they were both able to defer $24,500 (total of $49,000). They used the proceeds from the house sale to supplement the income that they were losing in their paycheck. Not only did they reduce their ordinary income tax for the year from $100,000 to $51,000 saving a bunch in taxes but they also were able to move the full $40,000 in long term capital gain income into the 0% tax bracket. Here’s how the numbers work:
Gross Income: $100,000
Pre-tax 401(k) Contributions: ($49,000)
Less Standard Deduction: ($24,000)
Total Taxable Income: $27,000
In their case, they would be able to realize $50,200 in long term capital gains before they would have to start paying the 15% fed tax on that income ($77,200 – $27,000 = $50,200). Since they were below that threshold, they paid no federal income tax on the $40,000 saving them $6,000 plus they also saved more in taxes by reducing their ordinary income via the 401(k) contributions.
“Filling The Bracket”
The strategy that I just described is called “filling the bracket”. We find ways to reduce an individuals taxable income in the year that long term capital gains are realized to “fill up” as much of that 0% long-term capital gains tax rate that we can before it spills over into the 15% long-term capital gains rate.
More good news, it’s not an “all or none” calculation. If you are married, have $60,000 in taxable income, and $100,000 in long term capital gains, a portion of your $100,000 in capital gains will be taxed at the 0% rate with the majority taxed at the 15% tax rate. As you might have guessed the IRS is not going to let you get away with paying 0% on a $100,000 in long term capital gains because you maneuvered your taxable income into the 0% cap gain range. But in this case, $17,200 would be taxed at the 0% long term cap gain rate, and the reminder would be taxed at the 15% long term cap gain rate.
Do Capital Gains Bump Your Ordinary Income Into A Higher Bracket?
When explaining this “filling up the bracket” strategy to clients, the most common question I get is: “If long term capital gains count as taxable income, does that put my ordinary income into a higher tax bracket?” The answer is “no”. In the eyes of the IRS, capital gains income is determined to be earned “after” all of your other income sources.
In an extreme example, let’s say I have $70,000 in ordinary income and $200,000 in capital gains. If my total ordinary income was $70,000 and I file a joint tax return, my top fed tax bracket in 2018 would be 22%. However, if the IRS decided to look at the $200,000 in capital gain income first and then put my ordinary income on top of that, my top federal tax bracket would now be 35%. That would hurt tax wise. Luckily, it does not work that way. Even if you realized $1M in long term capital gains, the $70,000 in ordinary income would be taxed at the same lower tax brackets since it was earned first in the eyes of the IRS.
Work With Your Accountant
Before I get into the more advanced strategies for how this filling up the brackets strategy is used, I cannot stress enough the importance of working with your tax advisor when executing these more complex tax strategies. The tax system is complex and making a shift in one area could hurt you in another area.
Even though these strategies may lower the federal tax rate on your long-term capital gain income, capital gains will increase your AGI (adjusted gross income) for the year which could phase you out of certain deductions, credits, making you ineligible for making Roth IRA contributions, reduce college financial aid, etc. Your accountant should be able to run tax projections for you in their software to play with the numbers to determine the ideal amount of long-term capital gains that can be realized in a given year without hurting the other aspects of your financial picture.
Strategy #1: I’m Retiring
When people retire, in many cases, their taxable income drops because they no longer have their paycheck and they are typically supplementing their income with social security and distributions from their investment accounts. This creates a tax planning opportunity because these taxpayers sometimes find themselves in the lowest tax bracket that they have been in over the past 30+ years. Here are some of the common examples.
Example 1: The First Year Of Retirement
If you retire at the beginning of the calendar year, you may only have had a few months of paychecks so your W2 wages or income flowing through from the business may be lower in that year. If you have built up cash in your savings account or if you have an after tax investment account that you can use to supplement your income for the remainder of the year to meet your expenses, this may create the opportunity to “fill up the bracket” and realize some long-term capital gains at a 0% federal tax rate in that year.
Example 2: Lower Expenses In Retirement
We have had clients that were making $150,000 per year and then when they retire they only need $40,000 per year to live off of. When you retire, the kids are typically through college, the mortgage is paid off, and your expenses drop so you need less income to supplement those expenses. A portion of your social security will most likely be counted as taxable income but if you do not have a pension, you may have some wiggle room to realize a portion of your long-term capital gains as a 0% rate each year.
Assume this is a single filer. Here is how the numbers would work:
Social Security & IRA Taxable Income: $40,000
Less Standard Deduction: ($12,000)
Total Taxable Income: $28,000
This individual would be able to realize $10,600 in long term capital gains each year at the 0% fed tax tax because the threshold is $38,600 and they are only showing $28,000 in taxable income. Saving $1,590 in fed taxes.
Financial Nerd Note: To my fellow financial nerds out there, in the example above, I’m aware that the amount of an individual’s social security benefit that counts as taxable income will vary based on that individuals AGI for the year but I wanted to keep the examples as simple as possible to illustrate the overall strategy.
Strategy #2: Business Owner Experiences A Low Income Year
If you have been running a business for 5+ years, you have probably been through those one or two tough years where the income from the business takes a nose dive for year or you invest a lot of money back into the business and end up showing very low taxable income for that year. Do not let these low taxable income years go to waste!!! If you are used to making $250,000+ per year and you have one of these low income years, start planning as soon as possible because once you cross that December 31st threshold, you will be out of luck. If you are showing no income for that year, you may want to talk to your accountant about realizing some long term capital gains in your brokerage account to realize those gains at a 0% tax rate. Or you may want to consider processing a Roth conversion in that low tax year. There are a number of tax strategies that will allow you to make the most of that “bad year” income wise.
Strategy #3: Leverage Cash Reserves and Brokerage Accounts
If you have been building up cash reserves or you have a brokerage account that you could sell some holdings without incurring big taxable gains, you may be able to use that as your income source for the year which could result in little to no taxable income showing for that tax year. We have seen both retirees and business owners use this strategy.
Business owners have control over when expenses will be realized which influences how much taxable income is being passed through to the business owner. If you can overload expenses into a single tax year instead of splitting it evenly between two separate tax years, that could create some tax planning opportunities.
There are few strategies that allow you to pay 0% in federal taxes on any type of gain. If you are a high income earner, this strategy may not work for you every year but there may be opportunities to use them at some point if income drops or when you enter the retirement years. Again, don’t let those lower income years go to waste. Work with your accountant and determine if “filling the bracket” is the right move for you.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.