Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.
Most people believe that the tax rate on capital gains is 15%. However, qualified dividends and long-term capital gains actually follow a bracket structure with three separate rates that are dependent on the client’s total taxable income. This can create some really interesting opportunities for people in the know.
Additionally, for higher income people, the notorious 3.8% additional income tax on net investment income creates an 18.8% or 23.8% capital gains and qualified dividends rate.
The tiered structure of the capital gains brackets creates unique opportunities to take advantage of the zero percent rate. For instance, for a married couple in 2018, the standard deduction is $24,000 plus an additional $2,600 if both are over 65 years old or blind. That means a married couple filing jointly, both over 65, could actually have $103,800 of capital gains and pay no federal income tax at all!
The challenge with the calculation is that it includes other taxable income. In other words, if a couple had $26,600 of IRA withdrawals and no other income sources, and also had $75,000 of capital gains, the standard deduction would prevent any of the IRA withdrawals from being taxable, and the capital gains would be taxed at a zero percent rate (because ordinary income plus capital gain minus the standard deduction falls below $103,800). If the same couple had $100,000 of capital gains, the first $77,200 of capital gains would be tax free at the zero percent rate, but the remaining $22,800 would be taxed at 15%.
Why does the zero percent rate matter? There are often opportunities to capitalize on the zero percent capital gains rate, particularly for people who are recently retired and have a choice from which accounts they should be spending. Many are holding a highly appreciated stock or mutual fund that is no longer a good fit for their financial plan, but they are afraid to sell it because they don’t want to pay tax on the gain. In that situation, consider forgoing any withdrawals from the IRA in order to sell as much of the appreciated stock as possible without paying tax.