Most people are stunned to learn that the lowest federal capital gains tax rate is 0%. That is right. Tax-free. And while it does not apply to everyone, with the right planning, some of those capital gains in your investment portfolio could result in zero tax. For 2018 the 0% capital gains rate applies to married tax filers with taxable income up to $77,400. Taking the new $24,000 standard deduction into account means that a married couple can generate $101,400 in income and still pay zero percent federal tax.
While you may be far above those income levels now, you may be able to recognize capital gains for zero Federal tax in a ‘low-income year,’ such as when you are temporarily unemployed, have a business loss, or are retiring. Alternatively, you may be able to ‘harvest’ gains each year, providing for your retirement needs, while staying in the zero percent bracket.
For example, let’s consider the case of a hypothetical executive Ed, who is retiring in 2018 and will have zero wage income. Ed bought his company’s stock all of his life, and now has $1,000,000 in his company’s stock with a basis of only $500,000. Now that he is retired, he would like to get out of this concentrated position and needs to use the stock to help provide for his $150,000 in living expenses each year. By delaying distributions from any other retirement accounts, Ed could sell $150,000 of his company stock each year, generate $150,000 in cash flow for himself, recognize only $75,000 in capital gains, and pay no Federal tax on the gains. By comparison, selling all of the stock outright would result in a $500,000 gain, pushing Ed into the 20% capital gains bracket, and cost Ed $100,000 in taxes.
Going over the $77,400 threshold will result in a 15% tax on the capital gains, so it is important to be accurate and consider all income sources. For example, most mutual funds generate income and capital gains each year. Do your research, review your tax returns, and consider using a tax professional before you start intentionally selling stock to recognize the gains.
The key to this strategy is planning. If you find yourself in a low-income year or are retiring, consider your options for pulling funds from your investments. You may have tremendous flexibility to pull funds from 401ks, pensions, deferred compensation plans, savings, rental properties, and appreciated stock. By developing a distribution strategy that considers the taxation of each of those assets, you may be able to dramatically lower the tax that you will eventually pay.