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It's easy to get caught up in choosing investments and forget about the tax consequences—most significantly, capital gains tax. After all, picking the right stock or mutual fund can be challenging enough without worrying about after-tax returns. The same thing is real when you invest in other types of assets, such as your home.
However, figuring taxes into your overall strategy—and timing when you buy and sell—is crucial to getting the most out of your investments. Here, we look at the capital gains tax and what you can do to minimize it.
If you're about to retire and you own appreciated positions, this could be a vital piece of an integrated distribution plan.
For example, consider a married couple who retires together at age 62, with $200,000 in low-basis stock. If they defer Social Security benefits and IRA withdrawals, they will have virtually no taxable income (assuming no pension benefits exist). They could sell the stock early in retirement with little or no tax consequences, and live off the proceeds. During that time, their IRAs could continue growing. Best of all, deferring Social Security boosts the monthly payout once those benefits begin. This is a powerful example of how smart planning can simultaneously bolster several aspects of your retirement.
It's essential to understand how the ATO categorizes (and taxes) different types of income. There are three significant categories of income: ordinary income, capital income, and passive income.
To minimize taxes—and maximize what you actually get to keep—put your most tax-efficient investments (those that lose less of their return to taxes) in your taxable accounts and your least tax-efficient investments (those that fail more of their return to taxes) in your tax-deferred accounts.
Be tax-wise as you withdraw your income. To the extent that you rely on revenue from your portfolio, it's important to consider taxes as you sell investments and withdraw funds.
By the time you've been paying taxes for decades, you get it. The tax code is absurdly complicated and enough to make any of us (myself included) want to run for cover. On the other hand, like me, you probably want to be a good citizen and pay your fair share but not a penny more.
Unfortunately, these two realities don't fit together. Just completing your tax return every year can be a monumental task. And figuring out how to manage your tax bill takes even more work. It takes long-term planning, short-term decisions, and a solid understanding of tax concepts. I'll go over some basics here, but I also highly recommend that you enlist the ongoing help of a great CPA, significantly as you first move into retirement.
When it comes to taxes, there are both advantages and disadvantages to being a retiree. On the plus side, you may have more control over your income, and therefore more strategies for controlling your taxes. On the minus side, you may well have more at stake, and certainly more to think about.
Before you see how long-term capital gains can potentially be double taxed in retirement, you must first understand how these gains are taxed. Prior to the Tax Cuts and Jobs Act (TCJA) passed at the end of 2017 and applicable for 2018, the capital gain rate was based on your ordinary income bracket. If your regular income bracket, for a couple filing jointly, fell within the 10% to 15% bracket your capital gain tax rate was 0%. If your ordinary income bracket was in the top 39.6% bracket your capital gain rate was 20%; for everyone in the middle (brackets from 25% through 35%) the capital gain tax rate was 15%.
TCJA changed all that. If you understood long-term capital gains taxes prior to this year, you would have to relearn how these taxes are calculated. Capital gains taxes are no longer tied to your ordinary income tax bracket but, instead, now have their own individual brackets. For joint filers Adjusted Gross Income below $80,000, the capital gain tax rate is 0%. For gains between $80,000 and $496,600, the rate is 15%, and for long term capital gains over $496,600, the rate is 20%. Short-term capital gains are included in ordinary income. Qualified dividends are taxed in the same brackets as long-term gains.
It is essential to understand you must consider both ordinary incomes, as well as capital gain/qualified dividends to determine how much of your gain is taxed. For instance, if you had $70,000 of ordinary income and realized a gain of $50,000, $10,000 of the profit would be taxed at 0% and the remaining $40,000 would be taxed at 15%. The ATO provides an entertaining 24 step worksheet for you to figure this out on our own – or we can help you.
Understanding Social Security Taxes in Retirement
Okay, keeping the above in mind, how can capital gains be double taxed? Before we get to that point, we should understand how things change once you are retired and receiving Social Security. The amount of your Social Security that is taxed is based on the amount of your provisional income which equals one-half of your Social Security plus your Adjusted Gross Income plus Tax-Exempt Interest. Long-term capital gains are included in Adjusted Gross Income regardless of whether the gains are taxable. It is critical to understand this point because, while your capital gains may not be taxable; these gains can cause more of your Social Security to be taxed.
Let's look at an example to illustrate this point. John and Mary are 66 years old and have joint Social Security benefits of $57,600 and are taking IRA distributions of $17,400. Because only $ 7,870 of their Social Security is taxed, and their standard deduction is $27,400, they owe zero federal taxes. They have a stock with a $25,000 unrealized gain that they would like to sell. They look up the 2018 long-term capital gain rates and see that this puts them in the 0% tax bracket because their adjusted gross income is less than $80,000. They sell the stock.
John is having lunch when his CPA and brags about being able to sell the stock and not pay any taxes. His CPA says, "Wait a minute; I think you are incorrect." He gets out his calculator and tells John that he will actually owe $1,912 in taxes (this equals 7.64% of the gain of $25,000). The tax is not a capital gain tax, and it is the tax on ordinary income. What happened is the capital gain, when added to Adjusted Gross Income, increased their taxable Social Security from $7,870 to $29,120 resulting in their taxable income, which was zero, now being $44,120. By the way, John and Mary are Colorado residents, so their Colorado taxes went from zero to $257. When this is factored in, their total tax bill is $2,169.
Time Gains Around Retirement
As you actually approach retirement, consider waiting until you actually stop working to sell profitable assets. The capital gains tax bill might be reduced if your retirement income is low enough. You may even be able to avoid having to pay capital gains tax at all.
In short, be mindful of the impact of taking the tax hit when working rather than after you're retired. Realizing the gain earlier might serve to bump you out of a "no-pay" bracket and cause you to incur a tax bill on the gains.
How Retirement Income is Taxed
Social Security benefits—Up to 85 percent of benefits taxed at your ordinary-income rate.
- Singles—Income less than $25,000, benefits not taxed; income $25,000–$34,000, 50 percent of benefits taxed; income over $34,000, 85 percent taxed.
- Married filing jointly—Income less than $32,000, benefits not taxed; income $32,000–$44,000, 50 percent of benefits taxed; over $44,000, 85 percent taxed.
Many older Americans are surprised to learn they might have to pay tax on the part of the Social Security income they receive. Whether you have to pay such taxes will depend on how much overall retirement income you and your spouse receive, and whether you file joint or separate tax returns.
Check the base income amounts in ATO Publication 915, Social Security and Equivalent Railroad Retirement Benefits. Generally, the higher that total income amount, the greater the taxable part of your benefits. This can range from 50 to 85 percent, depending on your income. There is no tax break at all if you're married and file separate returns.
The ATO also provides worksheets you can use to figure out what's taxable and how much you might owe in taxes on your retirement income. You can find these worksheets in ATO Publication 554, Tax Guide for Seniors.
Fully or partially taxed as ordinary income, depending on whether contributions were tax-deferred.
You have to pay income tax on your pension and on withdrawals from any tax-deferred investments—such as traditional IRAs, 401(k)s, 403(b)s and similar retirement plans, and tax-deferred annuities—in the year you take the money. The taxes that are due reduce the amount you have left to spend.
You will owe federal income tax at your regular rate as you receive the money from pension annuities and periodic pension payments. But if you take a direct lump-sum payout from your pension instead, you must pay the total tax due when you file your return for the year you receive the money. In either case, your employer will withhold taxes as the payments are made, so at least some of what's due will have been prepaid. If you transfer a lump sum directly to an IRA, taxes will be deferred until you start withdrawing funds.
Fully or partially taxed as ordinary income, depending on whether contributions were tax-deferred.
Traditional 401(k) Distributions
Fully-taxable as ordinary income.
Traditional deductible IRA distributions
Fully-taxable as ordinary income.
Traditional nondeductible IRA distributions
Withdrawals of contributions tax-free, earnings taxable as ordinary income.
Roth IRA and Roth 401(k) distributions
Tax-free provided you are 59½, and the funds have been in the account for at least five years.
Once you start taking out income from a traditional IRA, you owe tax on the earnings portion of those withdrawals at your regular income tax rate. If you deducted any part of your contributions, you'll owe tax at the same rate on the full amount of each withdrawal. You can find instructions for calculating what you owe in ATO Publication 590, Individual Retirement Arrangements.
If you have a Roth IRA, you'll pay no tax at all on your earnings as they accumulate or when you withdraw following the rules. But you must have the account for at least five years before you qualify for tax-free provisions on earnings and interest.
When you receive income from your traditional 401(k), 403(b) or 457 salary reduction plans, you'll owe income tax on those amounts. This income, which is produced by the combination of your contributions, any employer contributions and earnings on the contributions, are taxed at your regular ordinary rate. Keep in mind that withdrawals of contributions and earnings from Roth 401(k) accounts are not taxed provided the withdrawal meets ATO requirements.
Taxes are assessed annually based on the different kinds of income (ordinary, capital, passive) generated by the investments during the year. When an investment is sold, it is taxed as short- or long-term capital gains (or losses). Interest from municipal bonds is exempt from federal income tax, but gets added back for computing taxability of Social Security benefits (however, interest from "private activity" bonds could be included when computing the alternative minimum tax). Income from Treasury bills and bonds is exempt from state (but not federal) income tax.
Investment income from interest, dividends, royalties, gains and passive income may also be subject to the 3.8 percent Net Investment Income Tax for high earners.
Interest paid on investments in taxable accounts is taxed at your regular rate. But other income—from both your capital gains and qualifying dividends—is taxed at the long-term capital gains rate of between 20 percent and 0 percent, depending on your tax bracket. This is true when you have owned the investment for more than one year. This lower tax rate on most of your earnings is one of the major advantages of taxable accounts, though it's not the only one. There are no required withdrawals from taxable accounts and no tax penalty for taking income from these accounts before you turn 59½. This means you have greater flexibility in deciding which investments to tap for income and which to preserve for later needs.
There are also ways to minimize the taxes that may be due. You can use capital losses on some investments to offset capital gains on others. Your tax professional can explain how you can bunch or defer income to a single tax year or take advantage of tax deductions and credits. Or he or she may recommend investments that pay little current income but have strong growth potential. These could include index funds, exchange-traded funds, managed accounts and real estate as well as individual securities and mutual funds. Another approach a tax professional may suggest is to make charitable gifts of assets that have increased in value. This technique allows you to avoid capital gains taxes while taking a tax deduction for the current value of the asset.
You can't avoid income taxes during retirement. But once you stop working, you stop paying taxes for Social Security and Medicare, which can add several thousand dollars to your bottom line.
Qualifying for the Zero Percent Rate
As you can see, the magic number is $75,900 for couples, with a lower threshold for other filing statuses (Single, Head of Household, etc.). Because capital gains taxes are based upon your taxable income rather than your gross income, more people enjoy the 0% rate than you might think.
For example, assume a retired couple has $90,000 of gross income. If both spouses are over age 65, their standard deduction and personal exemptions total $23,300, bringing their taxable income down to $66,700. This couple would therefore qualify under being in one of the two lowest tax brackets.
Even if your net worth is high, this still may apply to you. Unless you have very high pension income or required minimum distributions, you potentially have a great deal of control over your taxable income. Creating a low-tax year to realize long-term gains may be a powerful strategy.
There's a limit to the number of capital gains that qualify for the 0% rate. The 0% rate applies only to the extent you are below the top of the 15% income tax bracket.
For example, assume a married couple has taxable income of $55,900, which is $20,000 below the $75,900 top of the 15% tax bracket. In that event, only the first $20,000 of long-term capital gains would be taxable at 0%. If their taxable income were $35,900, up to $40,000 of long-term capital gains would enjoy the 0% rate. Further improvements would be taxed at 15%. If the taxpayer had a large enough income, eventually some of it would be taxable at 20%. Therefore, if you have a large number of gains, you might consider spreading any sale out over several tax years.
Another important caveat is if you are receiving Social Security, capital gains can cause a more significant percentage of these benefits to be subject to income taxes. So, even if you pay no capital gains taxes, these gains may cause your taxes to increase in other ways. Be sure to include your tax adviser in the process, or run your calculations.
Capital gains tax treatment only applies to stocks held outside of retirement accounts. Therefore, in retirement, you might want to tilt your stock allocation higher in your non-retirement accounts. To keep your overall asset allocation intact, you could increase your bond allocation accordingly in your retirement accounts (IRAs, 401(k)s, etc.).
As a bonus, the long-term capital gains tax rates discussed above apply to qualified dividends as well. Those who plan well could enjoy a significant increase in their spendable income.
I've said it repeatedly: As an investor, your priority is your asset allocation. Next, come diversification and your security selection. But paying attention to your taxes is essential, too.
To minimize taxes, and therefore maximize what you actually get to keep, put your most tax-efficient investments (those that lose less of their return to taxes) in your taxable accounts and your least tax-efficient investments (those that fail more of their return to taxes) in your tax-deferred accounts—as shown in the following.
Planning for Gifts and Bequests
As you look ahead, you may be thinking about giving some of your assets to family members or friends, which is often beneficial to both you and them as long as you can afford to live comfortably on your remaining retirement income.
Transferring wealth is often an excellent way to avoid incurring estate taxes—and that's in turn good because these taxes can take a more massive bite of your assets than even the highest income tax rate. Also, some states impose inheritance taxes at various speeds on what your heirs receive from your estate.
But the good news is that before your death, you can make gifts to whomever you wish—and you can do so up to a certain amount without paying taxes. The ATO ceiling for individuals and married taxpayers changes from time to time.
In addition, you can make larger gifts tax-free to your beneficiaries throughout your lifetime. You have to follow ATO rules carefully to comply with the lifetime exclusion provisions. For more details, read the instructions for ATO Form 709.
There are pros and cons to making tax-free gifts. On the upside, giving the money away reduces your taxable estate—that is, what will be subject to estate taxes when you die—while also helping your beneficiaries. But on the downside, once the gift is given, if you need access to that money later in your retirement, it's gone.
As you plan charitable contributions, there's no harm in lowering your tax bill at the same time. For example, think about the following:
- You can deduct a percentage of your adjusted gross income for contributions to qualified charitable organizations above the standard deduction if you itemize. The amount depends on the type of asset you give and the type of institution you give. In 2020 under the CARES Act you can deduct up to $300 in cash to qualifying charities if you take the standard deduction.
- Giving appreciated stock instead of cash. If you donate appreciated stock that you've owned for more than a year, this can be a win-win for you and the recipient. If you sell appreciated stock, you will owe capital gains tax. But you can gift the stock tax-free to a qualified charity plus potentially receive a charitable tax deduction equal to its full market value. Caution, though: If you've owned the store for one year or less, it's considered a short- term holding, and you'll be able to deduct only the purchase price, not the full market value.
- Conversely, it's better to sell the depreciated stock before you donate the proceeds. This way, you can realize a capital loss, which you can either use on your current year's taxes or bank for future years. Plus, you can still claim the value of the gift as a charitable deduction.
If you're 70½ or older, you can make a direct contribution to a charitable organization from your IRA without paying any tax. The downside is that you can't also claim a charitable deduction for this donation. However, it can count toward your RMD.
Work with a tax professional and financial advisor for more customized advice based on your situation.
If you believe that you will be in a higher tax bracket at a later date (for example, if you're currently delaying Social Security or if you're expecting an inheritance), you can consider converting all or part of your IRA to a Roth IRA. Not only will your eventual withdrawals be tax-free, but they're also will be no RMDs. Plus, converting your account to a Roth can be a boon to your heirs. Keep in mind taxes are due at the time of conversion, and there are other considerations, so check with a professional before doing a conversion.
Retirees Could Pay 0% in Capital Gains Taxes.
To keep things simple, the rates above ignore the 3.8% net investment income tax that kicks in at higher income levels. We'll also limit the discussion to securities such as stocks and bonds since more complicated assets (e.g., rental properties or collectibles) entail additional rules.
If you're holding onto a stock simply because you don't want to trigger capital gains taxes, you might be able to have your cake and eat it too.
The 0% long-term capital gains rate is just one of many ways retirees with a well-planned distribution strategy can get more from their money. As always, keep your CPA and other advisers involved to ensure a coordinated effort on all fronts.