Pay Zero Taxes with Over $120,000 in Income - Capital Gains Strategy
Discover how to pay 0% in taxes on over $120,000 in income. Tim reveals how to leverage the 0% capital gains tax bracket, explains the difference between ordinary income and capital gains tax rates, and shares a powerful strategy called "tax gain harvesting."
Yes, it is possible to pay zero taxes with over $120,000 in income. First, understandably, there is much confusion on how our tax code works, and one of the most common areas of confusion comes from the fact that we actually have two separate income brackets.
We have our ordinary income tax rates, with the 7 bracket rates, which most are familiar with. Then we have the more favorable rates for qualified dividends and long-term capital gains, which have 3 brackets of rates. In this favorable, 3-bracket part of the tax code, there is a 0% tax rate bracket, a 15% bracket, and a 20% bracket on investment income.
This provision, which has been in effect since 2008, allows individuals or those married filing jointly, to pay no taxes on their capital gains and qualified dividend income from taxable investment accounts. And, despite its existence for over a decade, many taxpayers are unaware of this opportunity, or they don’t understand how it works - again because of the complexity of our US tax code.
How it Works
To qualify for the 0% tax rate in 2024, single filers need to have income below $47,025, and couples married filing jointly, need income below $94,050. Also, further adjustments to taxable income, from the standard deduction, can expand the portion of income subject to this rate.
For instance, single filers with a standard deduction of $14,600 could potentially have up to $61,625 of capital gains and dividends taxed at 0%, while couples who are married filing jointly with a standard deduction of $29,200 could have up to $123,250 in the zero percent capital gains bracket. That is over $120,000 of income, with no taxes owed to the IRS. Not bad.
Now, when can we use this? Well, the 0% rate bracket can be beneficial for those experiencing lower taxable income periods. For instance, maybe you’re between jobs and will have a lower income one year, or maybe you’ve retired and have not yet begun taking Social Security, pensions, IRA withdrawals, or anything that would cause ordinary income.
This is because there is a stacking rule that requires eligible income to be added on top of other income, potentially reducing the benefit for higher-income individuals. So, careful planning is necessary to take full advantage of this tax-saving opportunity.
Maybe you’ve heard of tax-loss harvesting. Well, this is tax-gain harvesting, where we are filling up a 0% bracket, by selling an investment with a long-term capital gain and then buying back the same investment, if we want to, in order to lock in those gains at the 0% bracket.
Why do we do this? To lower lifetime tax liabilities! Because when do we want to pay taxes? We want to pay them when they are the cheapest, right?
Example 1: No Other Income
Let me give you an example of how this might work. Let’s say a married couple just retired, and they’ve owned Caterpillar stock* for a long time. They want to keep owning that stock, but they’re sitting on $400,000 of long-term capital gains.
Now, let’s say they aren’t going to have any income in 2024 because they recently retired, and they won’t have earned income and haven’t flipped on Social Security or pensions yet, and they have over a decade before they have to start taking RMDs.
They also have a decent chunk of cash in their bank account, so they can just use that money for living expenses this year. In this case, we’re going to sell enough CAT stock* to lock in $123,250 in long-term capital gains. Then we’re going to buy it back the next day. So now they still own Caterpillar stock, but they just locked in a zero percent tax rate on $123,250 in long-term capital gains. So, again, that is over $120,000 in income with no taxes owed to the IRS!
Example 2: Including Social Security Income
Now, let’s cover a more common scenario. Let’s say you’re a retired married couple filing jointly and both age 64. And let’s say you have that same $400,000 in long-term gains in CAT stock, but you’re both receiving your Social Security benefit.
If you only have Social Security on your tax return, you won’t have to pay any federal income taxes. But if you’re going to need future income from your taxable account, and if you are sitting on a large unrealized gain, like the $400,000 gain in CAT stock, it might still be advantageous to go ahead and realize some investment gains.
Yes, this would cause your Social Security to become taxed because of the Social Security provisional income formula and associated thresholds. But it would be in the historically low 10 and 12% brackets, and you could still lock in investment gains in the zero capital gains brackets.
For instance, let’s say you have $40,000 in combined taxable Social Security income, and you have the standard deduction of $29,200. Recall from the previous example, you can maximize this strategy with $123,250 in the zero percent gains bracket, but now you have to subtract the $40,000 in taxable Social Security income.
So, you take $40,000 from $123,250 and that still gives you $83,250 you could show in realized investment gains in the zero percent bracket by selling CAT stock. And again, this is because the qualified dividends and capital gains brackets stack on top of ordinary income tax rates. Clear as mud, right?
Sometimes, when I mention this strategy, people say, "Hey Tim, what about the wash rule, how does that work?” Well, the wash rules states: if an investment is sold at a loss, and then repurchased within 30 days, the initial loss cannot be claimed for tax purposes. But the key word here, was loss, with tax gain harvesting we’re selling with a gain, so the wash rule doesn’t apply.
Bottom Line:
Many factors will play into if, and when, you should use this strategy. Factors like the size of taxable and tax-deferred retirement accounts, expected payouts, annual expenses, and federal and state taxes are going to play a key role in making this decision. But it’s a great strategy if you have eligible gains or dividends, especially if you have greatly appreciated assets.
A key point to remember is that capital gains stack on top of ordinary income, so for this to work, ordinary income must be relatively low. However, potentially paying 0% on capital gains of up to over $120,000 in income can have a significant impact on your overall financial well-being by limiting lifetime tax liabilities.
As I like to say, we always want to pay what we owe, but we never want to leave the IRS a tip.
*Note: Advisor is not recommending the purchase of specific individual stocks. The stock mentioned is for example purposes only.
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