What is the 0% tax rate and how can you pay zero federal tax on a portion of your income? This article will give you the basic concept on one strategy you can use to take advantage of the 0% federal income tax rate.
The basics – Individuals pay different tax rates on different types of income (as shown in the chart below). For simplicity, this article focuses on the differences between ordinary income and long-term capital gains/qualified dividends (“LTCG/QD”). Ordinary income includes wages, business income, IRA distributions, short-term capital gain and most other types of income. LTCG is the gain recognized on the sale of appreciated stock, mutual funds or ETFs (this tax concept does not apply to investments held in retirement accounts except for unique scenarios such as Net Unrealized Appreciation). QD are dividends paid by stock, mutual funds, ETFs, etc. during the year.
*Ordinary income tax rates are shown as ranges for presentation purposes only. Due to recent tax legislations the ordinary income tax and LTCD/QD tax brackets do not have the exact same taxable income thresholds so this general presentation of ordinary income tax rates is being used.
The goal is to take advantage of the 0% tax bracket on LTCG/QD. In order to qualify, you must first have taxable income less than $78,750 if married filing jointly or $39,375 if single. If you don’t itemize, this means you must have total income less than $103,150 if MFJ ($78,750 + $24,400 standard deduction) or $51,575 if single. If you do itemize your income threshold is even higher. For those who think their income is too high to qualify, remember the following major tax scenarios (among many others) that could cause your income to fluctuate downward in any given year:
Business Owner – Purchased significant equipment or vehicles this year and took accelerated depreciation.
Recently retired, decided not to take social security yet or did not take IRA withdrawals this year.
Completed a significant charitable donation this year which likely reduces taxable income.
If you think you will meet the income requirements shown above then you can complete a very simple, yet effective, strategy called “tax gain harvesting.” Many of you may be familiar with “tax loss harvesting” which is simply selling your loss investments prior to year-end in order to deduct the taxable loss on your income tax return for a particular year. Capital gain harvesting is the same process whereby you sell your gain investments prior to year-end and pay 0% federal income tax on those gains. Let’s go through an example to show you how this strategy works:
Example – Ken & Sally Smith file MFJ each year. Ken owns a small business with 5 employees and a fleet of work trucks. Sally earns $40,000 in W-2 wages and approximately $500 in qualified dividends from her Stryker stock investments she bought many years ago for $20,000 (worth $200,000 today). In 2019, Ken’s business is profitable with taxable income of $200,000, but Ken decided they should upgrade the fleet of trucks and bought 4 trucks totaling $160,000 (Ken chose to take 100% bonus depreciation on the trucks). Therefore, combined income for Ken & Sally is $80,500 ($40,000 + $500 + $200,000 - $160,000). Ken & Sally will report $80,500 income less $24,400 standard deduction and have taxable income of $56,100. Ken & Sally meet with their CPA in December 2019 and discuss how the year went and ask if there was anything else they should do before the end of the year.
“Sell $25,000 in Stryker stock” is the tax advice given by the CPA. Ken & Sally are confused by such a crazy idea to create taxable income and sell stock they don’t want to dispose of. Why would they do such a thing? The CPA knows they are under the $78,750 taxable income threshold by approximately $22,500 (78,750 - $56,100) which equates to $25,000 in value of the stock less $2,500 basis. Therefore, the CPA knows they can pay 0% federal income tax on the $22,500 in long-term capital gains. Then, if Sally wants to buy back the Stryker stock she can do so with that $25,000 the same day (wash-sale rules ONLY apply to loss sales so Sally has no restrictions when buying the same stock she sold previously). Therefore, Sally would go from owning $200,000 worth of stock and a future taxable gain of $180,000 ($200,000 - $20,000) to owning $200,000 worth of stock and a future taxable gain of $157,500 ($200,000 - $20,000 + $2,500 basis in stock sold - $25,000 basis in stock repurchased). Put another way, if all of the stock was sold in 2020 under normal income circumstances for Ken & Sally (no truck purchases in 2020) they would have a $27,000 federal income tax liability on the sale of Stryker stock. If they completed the tax gain harvesting in 2019. That is a $3,375 tax savings!! The difference is the $22,500 gain Ken & Sally paid 0% federal income tax on in 2019, they would have a $23,625 federal tax liability. If Ken & Sally expect their income to be above the $78,750 threshold in future years and don’t plan on donating the appreciated stock, then the tax gain harvesting strategy would be a wise decision for them to make. One important caveat to remember is the 0% tax rate is only applicable to your federal return – there will still likely be a state income tax due on the capital stock sale.
Tax gain harvesting is one approach to utilizing the 0% federal income tax rate. In fact, many of you are already paying 0% on your long-term gains and qualified dividends each year without knowing it. If you have any questions on your individual tax scenario and whether this strategy could apply to you, please contact your CPA.