By Jake Milder
A few months ago, a recently retired couple came to me exhibiting signs of acute financial planning neglect with bouts of financial clarity. In a recent meeting with their on-again, off-again broker, they decided to test their relationship with some questions they'd recently come across related to capital gains and withdrawal strategies. The blank stare on the broker's face is why I was meeting with them about two weeks later.
Their situation was interesting, perhaps even fun for geeks like me, but their question was not uncommon. With time, discipline and some good fortune, the couple had amassed a $1 million portfolio, approximately half of which was in taxable brokerage accounts and the other half in IRAs and 401(k)s. Due to several factors, their taxable accounts had a basis of only about $200,000, thus leaving them with a $300,000 taxable gain based on the market value of their securities. Their question to the broker was, "How do we recognize the $300,000 in gains without paying capital gains taxes?"
This article will answer their question, discuss the current capital gains tax structure, identify how people in varying life stages with differing levels of income can best use these strategies, and provide some important considerations prior to implementing them.
A Century of Capital Gains Taxes
Capital gains taxes in the U.S. can be traced back to 1913. Since then, numerous changes have been made, mostly by adjusting just two variables: the capital gains tax rate, and the amount taxpayers can exclude from taxation on the sale of capital assets.
In 2003, as part of the Jobs Growth and Tax Relief Reconciliation Act, a 0% tax bracket was created for those with lower income levels. It went into effect in 2008 and was made permanent in 2012. Today, capital gains taxes are divided into three tax rates, ranging from 0% to 20%, though many with higher levels of income will also pay a 3.8% net investment income (NII) tax as well. This does not include any state or local taxes that may also be assessed. However, even with the surcharge, a 23.8% long-term capital gains rate is, by historical standards, very low. For context, in the mid-1930s and late 1970s, Americans paid a top long-term capital gain rate of nearly 40%.
Our modern-day tax system is structured like a series of seven buckets stacked one on top of the other, with the largest on the bottom. A taxpayer fills one bucket by earning income up to the threshold. Every dollar earned after that fills the next higher tax rate bucket.
Similarly, the capital gains system uses a three-bucket system, excluding NII surcharges for high income earners. The strategy is to fill your 0% bucket with capital gains without pouring so much that it overflows into the next, larger (higher tax-bracket) bucket.
What's surprising to many, if not most people, is not only the existence of the 0% capital gains rate, but the limits of income to which it applies, or to use the bucket analogy, how large the 0% bucket really is. In 2018, a married couple filing jointly (MFJ) could have taxable income of $77,200 and their capital gains would fall within the 0% bracket. Those filing as individuals can earn half that, i.e. there's no "marriage penalty" here. In fact, almost 80% of American households earn less than this threshold, though admittedly many have limited or no capital gains with which to utilize these strategies in the first place.
Even those with household incomes over the threshold can benefit from how the system is structured, since capital gains tax rates are based on taxable incomes, not gross income or even adjusted gross income. Taxable income is calculated after deducting an itemized or standard deduction. That means a couple earning $60,000 using the newly-increased standard deduction of $24,000, still has over $40,000 of "capacity" or "room" before filling up their 0% bucket. A couple earning $100,000 who has a mortgage and other itemized deductions including gifts totaling $40,000, still has over $15,000 of room in their capital gains bucket. Keep in mind that mutual fund companies and other securities often pay capital gains at the end of the year so be careful not to get too close to the top of your bucket as any capital gains income over that threshold will be subject to the 15% rate and could even move you into a different tax bracket.
As with all things tax-related, there are some complexities to consider when filling your buckets. Remember that the traditional, seven-tiered income tax tables are subject to different tax rates and different brackets than the capital gains tax tables.
However, as you realize gains, not only are you filling your three-tiered stack, but you're also filling the seven-tiered stack because by realizing these gains, you're adding to your taxable income, even if these gains are subject to 0% taxes. This can have an impact on certain tax credits and in certain circumstances, cause you to move into the next taxable bracket when done incorrectly or in conjunction with other strategies. Using our example from above, a couple earning $60,000 could realize $40,000 of capital gains, but this will be added to their taxable incomes for purposes of calculating tax credits, taxation of social security and eligibility for some other benefits. Notably, the couple is in the 12% tax bracket up to a confusingly-close-to-the-0%-capital gains bracket limit of $77,400 (of course, 12% is the marginal rate and ignores the tiered nature of our tax system).
Also consider there may be better uses for your bucket capacity, such as a Roth IRA conversion. Converting assets from a traditional IRA to a Roth IRA will also fill your taxable income buckets, but unlike filling your allowable long-term capital gains bucket, and taxable income bucket, Roth conversions will actually be taxable at ordinary income rates under the normal income tax brackets and thus may actually increase your tax bill. Most financial and accounting professionals should be able to help evaluate what strategies will help you save the most money in the short and long run.
Let's look at how people in different age brackets may be able to use these strategies to their advantage.
In Your 20s and 30s
Given the employment challenges facing millennials today, many people in their 20s and 30s fall under the income limitations required to pay a 0% capital gains rate. To be sure, few young people have significant capital gains to realize in the first place, but there are those who inherited or were gifted stocks from their parents or grandparents. Given the market returns of the past nine years, it's likely that even with a stepped-up basis at the death of a parent or grandparent, they still have significant gains, assuming of course the money hasn't been spent. If they were gifted, the basis would likely have remained low and there's an even greater likelihood there are significant unrealized gains. With wage income (minus standard or itemized deductions) below the threshold, this presents a great opportunity to step up their basis and "harvest" their gains. Specifically, these individuals could sell these securities today and repurchase the securities tomorrow at a new, stepped up basis. This would add to their income, but this income would be subject to a 0% capital gains rate, assuming they qualify from an income standpoint. Don't forget, capital gains are not subject to the same wash-sale rules as capital losses, so there's no mandatory waiting period to repurchase the same or similar securities.
In Your 30s and 40s
Few people have career trajectories that move at a 45% angle. Maybe you're currently unemployed, in a transition looking for something new or are in the process of launching a business and have significant deductions. If these are times with relatively low income, this is a great time to consider realizing some of the gains embedded within your portfolio utilizing the strategies listed above.
In Your 50s Until You Retire
Many retirees, particularly in their earlier years of retirement while wage income is depressed and before beginning their required minimum distributions or RMDs, will qualify for the 0% long-term capital gains tax brackets. This is a good time to realize or step up your basis in your portfolio, just before entering retirement. This was the case for the couple coming to me at the beginning of the article; newly retired with a temporarily-reduced income.
For those individuals or couples with taxable income significantly over the income thresholds and looking to spread their wealth, consider gifting assets to their children or grandchildren if they fall under the threshold. Gifting the low basis securities and allowing them to realize the gains and step up the basis with their lower tax brackets will remove the assets, future dividends and appreciation from your estate, and means neither the parents (donors) nor the children (recipients) pays capital gains taxes, a savings of over 23.8% or more depending on your state. When implementing this strategy, consider current gifting limits -- unless you don't mind filing some additional paperwork and subtracting your gift from your allowable gift/estate exemption -- and more importantly, be careful about gifting to children under 24 lest you invoke the "kiddie tax".
The couple in the beginning of the story began a strategy of realizing between $40,000 and $50,000 of capital gains per year until their income goes up and moves them back above the 0% threshold. While they may not be able to realize all of their existing gains, I anticipate doing this will save them at least $30,000.
About the author: Jacob Milder, CFP® is a financial planner and founder of Oak Street Investment Advisors LLC, a Fee-Only Registered Investment Advisor based in Denver Colorado. Oak Street Investments offers comprehensive financial planning and investment management services and specializes in working with business owners, technology and healthcare professionals. Milder is also a member of the FPA of Colorado.