You can have a significant amount of income and yet pay no income taxes on your long-term capital gains and qualified dividends. Most retirees and many other individuals shouldn’t have to pay income taxes on those types of income.
The key is to know about the tax brackets and when tax rates change for long-term capital gains and qualified dividends, which I’ll call tax-favored investment income (TFII). Other types of income are known as ordinary income. There’s a 0% tax rate on TFII as long as you’re in the 10%- or 12%-income tax bracket. In 2019, the 12% bracket tops out at $78,950 of taxable income for married couples filing jointly and $39,475 for single taxpayers. There’s only a 15% tax rate on TFII when you’re in the 22% tax bracket and most of the 35% tax bracket. You don’t pay the maximum 20% rate on TFII until your taxable income equals or exceeds $488,850 for married couples filing jointly or $434,550 for single taxpayers.
Here’s how the different tax brackets can play out.
Suppose Max and Rosie Profits are a married couple who file joint returns. They have $50,000 of taxable income before considering TFII. They’re in the 12% income tax bracket until their taxable income exceeds $78,950. That means the Profits could have up to $28,950 of TFII for the year and it would be taxed at the 0% rate.
The break points for the different tax rates are based on taxable income. Taxable income is what’s left after taking all your tax deductions and other breaks. Your gross income can be higher than these amounts, perhaps substantially higher, and with good tax planning someone with a high gross income still can benefit from the lower rates on TFII.
The standard deduction or your itemized expense deductions can be key to reducing your taxable income. Remember the 2017 tax law just about doubled the standard deductions. You take either the standard deduction or your itemized expense deductions, whichever is higher. Be-cause of the increased standard deduction and reduction in allowed itemized expense deductions, many more tax-payers will take the standard deduction instead of itemizing expenses.
Going back to Max and Rosie Profits, to determine their tax bracket they first take their gross income and subtract any deductions to arrive at adjusted gross income. Most retirees don’t have any deductions to arrive at adjusted gross income. These are listed on the new Schedule 1 that goes with the new Form 1040. Then they either take the standard deduction or itemize expenses. In 2019 they have a standard deduction of $24,400. So, even if they have no deductions for adjusted gross income, their $50,000 of taxable income means they could have gross income, other than TFII, of $74,400 and still be in the 12% regular income tax bracket and 0% bracket for TFII. They can have an additional $28,950 of TFII subject to the 0% bracket when their gross income other than TFII is up to $103,350.
Taxpayers age 65 and older receive an additional standard deduction of $1,300 for each spouse, which would allow the Profits taxable income of up to $105,950 before higher tax rates are triggered. The personal exemption amount was eliminated in the 2017 tax law. You can see how what I call tax bracket management can save a lot of money over time. It can help you stay in the 12% bracket on ordinary income and 0% bracket on long-term capital gains and qualified dividends. Or if your income is higher, you can keep your TFII in the 15% bracket and avoid the 20% maximum tax rate on it.
First, you need to estimate your itemized expense deductions for the year, so you’ll know if you’re likely to use the standard deduction or itemize expenses. When you’ll be itemizing expenses, you might be able to plan to maximize them for the year. Otherwise, you know you’ll be taking the standard deduction.
Second, you should estimate the income for the year you’ll receive that is out of your control. The income you don’t control can include Social Security benefits, pensions, annuities, required minimum distributions, and interest and dividends earned in tax-able accounts. Social Security benefits might or might not be included in gross income. A portion of the benefits, up to 85%, is included in gross income as your adjusted income increases. See our February 2019 issue for details. So, reducing adjusted gross income not only keeps your TAII in a lower tax bracket but also reduces income taxes on the Social Security benefits.
But there’s a key point that can result in some circular planning. Taking additional TAII increases your adjusted gross income (AGI). So, your initial planning might indicate that you can take a certain amount of long-term capital gains before rising to the next higher tax bracket. But those long-term gains increase your AGI, and that could increase the amount of Social Security benefits included in gross income. That, in turn, would reduce the amount of long-term gains you can take without being pushed into the next tax bracket.
So, you have to redo the calculations before making a final determination of the amount of TAII you can take. Distributions from mutual funds and exchange-traded funds are an-other type of income that’s out of your control, and you might not know the amount until near the end of the year. When the fund earns a long-term capital gain and distributes it to share-holders, those investors report it as long-term capital gains. When a fund earns a short-term capital gain and passes it through to shareholders, the shareholders are taxed on it as ordinary income.
Third, consider restructuring some of your portfolio to reduce gross income that’s out of your control. For example, you might shift investments that earn taxable interest into investments that earn tax-exempt interest. Also, stocks or mutual funds that earn non-qualified dividends could be sold and replaced with investments that pay qualified dividends or they could be moved into IRAs. Fourth, estimate the amount of long-term capital gains you can take without pushing your taxable income to the next higher bracket. Because of uncertainties about the taxation of Social Security income and distributions from funds, you probably want to have a cushion in this number. Finally, manage your investments to maximize the tax benefits. Avoid taking short-term capital gains. A gain is short-term when you held the investment for one year or less. Short-term gains are taxed as ordinary income. Take short-term capital gains only when the investment fundamentals dictate the action.
If you have investments with paper losses in taxable accounts, consider selling these to shelter capital gains and other types of income. You might want to sell some investments that have long-term capital gains assets even when you don’t need the cash. Suppose you own a stock that’s appreciated. You like it and want to continue holding it, but you haven’t taken enough gains yet to take you near the top of the tax bracket.
You could sell the stock and recognize the gain. Then, buy the stock back. The purchase re-establishes the basis in the stock as its current fair market value. So, you’ve taken the previous gain at a low tax rate (perhaps 0%), and you now have a higher basis. This ensures the gains you already earned won’t be taxed at a higher rate in a future year.
When you need cash to pay expenses, try to avoid taking additional distributions from traditional IRAs and 401(k)s. The distributions would be taxed as ordinary income and will increase taxable income. That could trigger higher tax rates across the board. Instead, try to take long-term capital gains when additional cash is needed, especially if the gains won’t push you into a higher bracket.
Let’s return to Max and Rosie Profits to show how to manage your tax bracket.
Max and Rosie both are older than 65 and retired. They’ll file a joint return and take the standard de-duction plus the additional amount for older taxpayers, giving them a standard deduction of $27,000 ($24,400 plus $2,600). They estimate taxable Social Security benefits will be $35,000 and they’ll receive about $15,000 in qualified dividends. That’s $50,000 of income other than long-term capital gains.
They can earn up to $105,950 of total income without rising into the next tax bracket (the $78,950 taxable income limit on the bracket plus their $24,400 standard deduction, plus the $2,600 additional standard deductions for both being over age 65).
So, they can recognize up to $55,950 of long-term capital gains and have them taxed at the 0% tax rate. As I said earlier, if the Profits have some investments with a lot of appreciation, they might want to sell them now to ensure the gains are taxed at the 0% rate and buy the investments back. That ensures if they need to sell the investments to raise cash in the future, the gains to date were taxed at the 0% rate. Selling the investments in the future to raise cash might push them into a higher tax bracket.
One way to enhance tax bracket management is to convert some of your traditional IRAs to Roth IRAs. This reduces required minimum distributions in future years. That reduces the amount of ordinary income over which you have no control and makes it easier for you to stay in the lower tax bracket. When you need additional cash, you can take a distribution from the Roth IRA. It will be tax free and won’t push you into a higher tax bracket.