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How to Pay Zero Taxes on Your Capital Gains
- By Travis Echols
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- 13 Aug, 2021
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation. |
Summary
For your capital assets outside of pretax retirement accounts which have large unrealized capital gains, tax gain harvesting may save you thousands of future tax dollars.
If you are in the lower income brackets for any reason, perhaps by design during the gap years between retirement and RMDs or delayed Social Security, you may be able to take advantage of 0% tax rates on long-term capital gains and avoid 15% or higher tax rates in the future. And it's hard to beat 0% taxes!
If you have both pretax savings in tax deferred retirement accounts (like IRAs and 401ks) AND large unrealized capital gains outside tax deferred accounts, Roth conversions and tax gain harvesting are two great strategies for reducing your lifetime taxes by paying lower taxes now to avoid higher taxes in the future.
Since accelerating ordinary income and harvesting capital gains both increase your taxable income in the year implemented, they can crowd each other out, meaning that Roth conversions may make more sense in one situation, whereas capital gains harvesting may be the best solution in another. And this can change from year to year for the same taxpayer.
Roth conversion and/or tax gain harvesting?
The idea of Roth conversions is that if you have a pretax IRA or 401k, all that money is not yours. Part of it is Uncle Sam's and he will get his share when you withdraw it.
If you have pretax savings in tax deferred retirement accounts (like IRAs and 401ks) AND large unrealized capital gains, you have two strategies that could potentially save you tens or hundreds of thousands of dollars over your lifetime.
But these two strategies compete with each.That's because these two strategies trigger two different types of taxes which both have two different progressive brackets applied to assess your tax liability.It takes some analysis to decide which strategy is best for each individual taxpayer...and it can change each year for the same taxpayer.
For some people, their IRA or 401k is a literal ticking tax time bomb that will result in unavoidable crushing tax rates in the future--and that is not even assuming higher tax rates due to factors such as the government needing to support entitlement programs for the wave of baby boomers retiring, etc.
But the good thing is you may have some control over when and how you withdraw or convert that money. And If you can pay $10,000 in taxes now to avoid $20,000 in taxes later (taking into account the time value of money), then Roth conversions can make a lot of sense.
This Roth conversion strategy could save you tens or hundreds of thousands of dollars over your lifetimes in ordinary income taxes by accelerating ordinary income in the lower brackets (10%/12%/22%/24%) to avoid future higher brackets (32%/35%/37%). Or filling up the 10 and 12% brackets to avoid the 22% and 24% brackets, etc.
For others, instead of avoiding future "ordinary income tax rates", you may be able to avoid higher "capital gains" taxes by harvesting long-term capital gains at 0%/15% to avoid 18.8%/23.8% brackets--or selling assets at 0% capital gains to avoid 15% or higher later...or selling at 15% to avoid 23.8% later.
At various income levels, it may make more sense to harvest capital gains rather than doing Roth conversions. (They can crowd out each other, so you need to pick which strategy is more advantageous each year based on your current and future tax projections. That is because capital gains are stacked on top of ordinary income minus deductions to establish your total taxable income.)
If you deliberately cause yourself or find yourself to be in the lower income brackets for any reason (maybe during the gap years between retirement and delayed Social Security or Required Minimum Distributions (RMDs)), paying ZERO taxes on a certain amount of capital gains to avoid future 15% tax rates or higher may be a better strategy than a Roth conversion.
It all depends on your situation as to which strategy is best--and this can change from year to year based on your situation and the current and future tax rates.
It could also be that the optimum strategy in a given tax year is a combination of a Roth conversion and capital gains harvesting.
The goal is to choose the optimal balance between Roth conversions and harvesting capital gains.Here is a flow chart to help with that decision.
For those of you who want to dig deeper,this Michael Kitces article, though using 2020 tax rates, goes into this topic in greater detail.
Below are 2021 tax rates for both ordinary income and capital gains.
Figure 1. 2021 Tax Rates
Note: This article you are reading is referring to long-term capital gains which are held for more than a year before they are sold for a gain. Short-term capital gains result from selling capital assets owned for one year or less and are taxed as regular ordinary income. Learn more here.
An example of harvesting capital gains at a zero percent tax rate
So how much long term capital gains can they harvest free of taxes by selling some of their highly appreciated assets in 2021? The answer is $60,000.
For older investors who have seen large gains due to strong stock market returns, their risk level may need to be reduced anyway, making this a win-win strategy.
However, unlike harvesting capital losses where there is a wash rule that mandates you wait 30 days before buying the same investment, there is no such rule for capital gains harvesting. So this couple can immediately buy the same stock or bond or fund that they sold.
The beauty is their new cost basis would now be a higher price, meaning future gains would now be based on the current higher market price rather than the lower share price they paid years ago.
Now, this couple will have to manage cash flow for their living expenses, so they may use some of the sold shares for their expenses (tax free from their taxable account) and reinvest the remainder.
If the couple has a strong confidence they will want to keep these investments for life AND there will never be a need to sell them AND long-term capital gains tax rates won't rise AND the step-up in cost basis at death won't be removed from the tax law in the future, they and their heirs may avoid capital gains through death. But those are a lot of things to count on, and it's hard to beat a zero percent tax rate, especially when the next bracket is 15%.
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- Liquidity--Retirement assets are not being locked up or annuitized such that capital is not available for emergencies.
- Income—Using an optimized withdrawal rate, an increasing income is produced to combat inflation (unlike many pensions, bank and insurance strategies that are not inflation-adjusted).
- Growth--assets that can combat inflation over a 20 to 30-year period, giving the retiree more income and upside potential under normal and good economic times.
- Safety--manages the myriad of investment risks like market risk, inflation risk, and credit risk. Under worst-case scenarios, if withdrawal amounts are adjusted by using guardrails, the portfolio can still provide a lifetime income.
Here is an executive summary of how to build up a portfolio for retirement in seven steps.
1. Values clarification and goal-setting . Figure out the income objective and capability of your retirement assets in lifestyle terms, then financial terms. In other words, set realistic, specific, financial goals based on your core life values.
2. Asset allocation glide path . Figure out how to diversify your retirement assets among stocks, bonds, and cash, based on your age, risk tolerance, retirement goals, and changing market values.
3. Valuation-dependent efficient frontier . Figure out which areas of the markets are historically inexpensive, and which are historically expensive. Don’t take on more volatility than you need to for the growth you need or desire.
4. Multi-asset class approach . Diversify one more step for more growth and less volatility. Put more money in the specific market areas that are less expensive and less money in the specific market areas that are more expensive.
5. Tax-aware asset location and distribution . Save as much on taxes as possible by figuring out which type of investments should be held in which types of accounts. If you are drawing an income from your assets, figure out the least-costly order for making withdrawals.
6. Investment selection based on account type (qualified, nonqualified) and asset-class propensity and magnitude of outperformance (passive, factor, managed, etc. ). Figure out what kind of investment to use (index mutual fund, factor mutual fund, actively managed mutual fund, single factor ETF, multifactor ETF, passive ETF, individual stocks, individual bonds, Unit Investment Trust, closed-end fund, etc.) based on the account type, asset class, and growth and income needs.
7. Rules-guided rebalancing based on retirement glide path and multi-asset-class approach . Readjust the investment mix based on your changing personal situation and changing market values.
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Here is a summary of the details backing this approach. Also, click here for more background information regarding my investment philosophy.
1. Values clarification and goal-setting
Investment planning for (or in) retirement starts with retirement planning. You start with thinking about your life goals...your dreams...your ideal life in retirement. It could involve doing no work, working part-time, or doing seasonal work. Your ideal life could be going back to school, spending more time with family, traveling, ministry, etc.
Ask yourself questions like, "What would I want to do if I
didn't need to work for money?" or "What are the most important
dangers, opportunities, and strengths I need to address?" or“Ten years from now, if I am looking back on a successful
ten years, what will I have achieved?”
This conversation allows you to create specific
goals around your most cherished values. And your goals will be unique to you.
You then design an investment plan to help you live your ideal life.
This kind of goal-focused, plan-driven approach minimizes the
chances of making bad investment choices based on current events and emotions.
Instead, you can choose and maintain the
specific mix of investments that can best deliver the results you need--using a
disciplined, research-driven approach.
2. Asset allocation glide path
The next major question is what kind of investments do you need to meet your goals. All investments have risk. Even "safe" investments over long periods have inflation risk. No single investment delivers growth, high income, and safety of principal. The key is designing a portfolio that balances them in a way that supports your retirement objectives.
And this mix may change over time. For example, for most people, it makes sense to gradually decrease their exposure to high-growth, high-volatility assets like stocks (i.e., equities) as they approach retirement. In retirement, it is usually best to maintain a flat equity glide path, dynamically adjusted for valuation. This approach protects you from the retirement-danger-zone risks of portfolio size effect and sequence risk, while allowing you to take advantage of bear markets and market corrections. See How to Navigate the Retirement Danger Zone .
Protecting your lifetime retirement savings from excessive taxes is a crucial part of holistic financial planning. This involves protecting your IRA, 401k, lump sum pension rollover, Social Security, and any other type of retirement account or income stream from crushing tax rates.
So let's be sure to differentiate tax preparation
from tax planning
.
Tax preparation , also called tax return preparation, looks backward, one year at a time, to get the numbers right to accurately calculate your tax liability (and how much you owe or overpaid).
Tax planning on the other hand looks at taxes in the context of your overall financial picture. A tax planner not only looks in the rear-view mirror but will look forward 20 to 30 years at your projected tax liability and ask what can be done to lower your lifetime tax bill.
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If you have savings outside of pretax retirement accounts invested in capital assets (like stocks, bonds, ETFs, mutual funds, precious metals, jewelry, and real estate) which have large unrealized capital gains, this article is for you. You may be missing the opportunity to pay zero taxes NOW instead of 15% or higher rates in the future. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
.
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Originally written on Aug 2, 2018 and updated for tax law changes.
If you are no longer working and have reached the age of 72,
you probably know about Uncle Sam’s rule for you to take a Required Minimum Distribution
(RMD) from your traditional and rollover IRA(s) each year for the rest of your life. You can always withdraw more,
but this requirement is the minimum
you must take or be severely penalized. Fortunately,
this rule does not apply to Roth IRAs. (The SECURE Act of 2019 changed the starting RMD age from 70½ to 72 starting in 2020, but fortunately you can still make a Qualified Charitable Distribution (QCD) starting the year you turn 70½.)
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If you have delayed paying taxes in your pretax IRA, 401(k), or 403(b), etc, there comes a time when the IRS wants their taxes. And if you don’t give them their taxes based on their required withdrawal schedule, you'll get hit with a 50% penalty on top of what you owed.
Along with Social Security and other retirement income, this RMD can significantly raise your tax rate. Also read How to Dodge the Social Security Tax Torpedo . There are not many ways to reduce this tax burden. In the past, retirees have used various deductions including charitable cash contributions and gifting of highly appreciated assets to charities. (The latter not only gives you, the donor, a deduction but also avoids a long-term capital gains tax bill.)
However, with the passing of the Tax Cuts and Jobs Act of 2017 (TCJA) , with its almost doubling of the standard deduction, itemizing deductions won’t make sense for near as many retirees. Ah, but there is still a strategy. But first let’s better understand the RMD.
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Whether you do mini-Roth conversions over several years or big Roth conversions in a few strategic years, the Roth conversion strategy could save you tens if not hundreds of thousands of dollars over your retirement. This article will get deep into the issues of Roth conversions for retirees and the ten steps to take to be sure it is done properly. Be sure to scan or read to the end where I will give you the simple answer to getting your Roth conversion questions answered. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Making big financial decisions immediately following the death of a close family member can be dangerous. It is often best to allow some time before tackling big financial decisions. On the other hand, some people find getting immersed in the finances is helpful in coping with the loss. Whatever way is best for you, you will need to give it your
careful attention to avoid big financial mistakes. The different types of accounts have different rules. I'll address the most common types. In the case of the death of a parent or anyone other than your spouse in which you are a non-spouse beneficiary, there are many rules that you must know to make the best decision for you and your family. (In this article, I use the common parent-child inheritance, but the planning strategies can apply to other non-spouse situations.) Your decisions can have major tax and investment consequences, both now and in the future. And some of these decisions have time deadlines keyed to your parent’s date of death. Also, some of these decisions are irreversible. You can download my free Estate Planning Survivor Checklist here
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So, you don’t want to rush in and make decisions without knowing the rules, and you don’t want to wait too long and be stuck with fewer options. (In this article, I am not addressing estate taxes. As of 2021, only estates valued at $11.70 million or more are subject to federal estate tax. But there are plenty of other tax pitfalls to navigate around. I am also going to focus on liquid savings like investment and retirement accounts, versus real estate which will be for another time.) Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation
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Delaying Social Security makes a lot of sense for many retirees; but there are common pitfalls that can cost you a bundle. As you know, the longer you delay your Social Security Retirement benefit, the higher your lifetime monthly payments are figured to be. This increase in delaying continues until age 70, after which there are no further increases for delaying. This increase for each month that you delay filing is not small, especially considering the current low interest rates. Even after full Social Security age, your payment goes up by 8% per year until age 70. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . Here are the five big mistakes of delaying your Social Security retirement benefit. |
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Are you wondering about the impact of the
2020 election results on your retirement? If so, you are not alone. The two political parties are greatly polarized. While the Democrat party has moved further toward ethno-centric socialism, the Republican party has moved further toward nationalistic populism. The difference in the two parties’ goals for our country is wider than ever. Sign up to receive my free monthly email articles on retirement planning--no cost, no obligation . |
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Investment Advisory Services offered through JT Stratford, LLC. JT Stratford, LLC and Echols Financial Services, LLC are separate entities.
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