“In this world nothing can be said to be certain, except death and taxes.” We’ve all heard this before. Anytime I do, I think immediately of Brad Pitt in the movie Meet Joe Black. He plays a personified version of death – Joe Black – who comes to take the life of Anthony Hopkins’ character. After taking an interest in Hopkins and his daughter, he decides to pardon him from death in exchange for a glimpse into what life is like for the living. In one scene, someone says to Black that nothing is certain but death and taxes. Having never heard this before, he finds it peculiar, if not a bit offensive. “Death and taxes?” he asks – “what an odd pairing.”
While death may not like his association with taxes, most of the time the saying holds true. We can mitigate taxes but not avoid them entirely. For those of us who are still working and earning a wage, our basic options for reducing taxes are to making less money or look for more deductions. It gets interesting; however, when you go from living off of your wages to living off of your portfolio. Your choices are no longer “less income or more deductions.” Your choice becomes “what kind of income do I want?” It is in this question that we find a loophole to Franklin’s death and taxes maxim. It is actually possible to have income and pay zero income tax.
Since 2003, the tax law says individuals and couples in the bottom two tax brackets pay a rate of 0% on long-term capital gain income. Let’s break down what that means:
Ordinary Income vs. Capital Gains
Ordinary income is money you earn from working or money you take out of a retirement account like a 401(k) or an IRA. Tax rates on ordinary income start at 10% and top out at 39.6%. It’s taxed at progressively higher rates, so we all pay 10% on the first $10,000 or so of income. The next $30,000 or so is taxed at 15%, and it goes up from there through all the brackets (25%, 28%, 33%, 35% and then the highest rate of 39.6% once you have taxable income over $415,000).
Capital gain income is a whole different animal. Capital gains occur when you sell an investment for more than what you paid for it. For example, if you buy 50 shares of DFA Global Equity for $1,000 in 2015 and sell it a year later for $1,200 you would have a $200 long-term capital gain that would go on your 2016 tax return. You are essentially paying taxes on your investment appreciation. Gains are only taxable in non-retirement accounts (think an individual or joint investment account, not an IRA) and they operate under a different tax rate schedule than ordinary income. Generally, people pay capital gains at a rate of 15%, 20% or…0%!
Which Capital Gain Rate Do You Pay?
Single taxpayers with less than ~$37,000 of income and joint filers with less than $75,000, pay the 0% capital gains rate. Once you exceed that level of income, you move into the higher rates on capital gains. Notably, even the highest capital gain rate is still much lower than the top rate on ordinary income (39.6%). This is why people like Warren Buffett who live off of profits from their investments (capital gains) can pay a lower rate than their secretary who is living off her much lower salary (ordinary income).
How to Pay 0%
In the time period between retirement and age 70, making use of the 0% capital gains rate can be a very effective way to create income. At retirement, most of us will go from a high tax bracket to a lower one. Even high-wage earners often find themselves in the bottom two tax brackets – making them eligible for the 0% capital gains rate.
When taking money from investments to pay for living needs, we can choose to take it from IRAs and 401(k)s (taxed at higher ordinary income rates) or from individual or joint investment accounts (taxed at capital gains rates). Let’s say a couple needs $70,000 to live on. If they take it from their IRA, they might pay $10,000 in federal tax. If the same couple took the money from their joint account, they could pay $0 federal income tax.
By taking advantage of the 0% capital gains rate, you may be able to take years of living needs from your investment accounts and avoid a significant amount of taxes on the appreciation of your assets. Even when your retirement income exceeds the limits for the 0% rate having both retirement and non-retirement accounts will give you the ability to plan retirement cash flow around tax efficiency. It is yet another layer of diversification.
So, perhaps taxes aren’t as certain as death after all. Unfortunately, I haven’t figured out a way around life expectancy yet. Maybe Brad Pitt can help us with that one.