If you need more incentive to generate passive income in order to give yourselves more freedom to do what you want, then look no further than the below two charts.
The short-term capital gains tax rate is equivalent to your federal marginal income tax rate. Once you hold your investments for longer than a year, the long-term capital gains tax rate kicks in and goes way down.
Capital Gains Tax Rates By Income For Singles
If you’re single, the largest tax spread difference between short-term and long-term is if you make $200,001 – $425,800 in capital gains. We’re talking a 20% lower tax rate (35% vs 15%).
To generate $200,001 – $425,800 in capital gains you could earn a 4% rate of return on $5,000,000 – $10,645,000 in capital, earn qualified dividends at the same rate with the same amount of capital, take profits on long-term holdings, or you can do a combination of everything.
For the 2018 tax year, you will not need to pay any taxes on qualified dividends as long as you have $38,600 or less of ordinary income. If you have between $38,600 and $425,800 of ordinary income, then you will pay a tax rate of 15% on qualified dividends. The rate for $425,801 or more is 20%.
Capital Gains Tax Rates By Income For Married Couples
If you’re married and file jointly, the largest tax spread difference between short-term and long-term is if you make $400,001 – $479,000 in capital gains. The difference is also 20% (35% vs 15%).
Obviously, few couples will generate such large capital gains on a regular basis. However, one scenario that does is when long-term homeowners in high cost of living areas sell their homes. They’ll first earn tax-free profits up to $500,000 if they’ve lived in their primary residence for two out of the last five years. Whatever profits are left will then face the various long-term capital gains tax rates.
Another scenario may be when a couple cashes in on their long-term stock options. There are plenty of couples who’ve worked at a private startup for years that finally goes public or gets acquired.
Beware Of The Net Investment Income Tax
Of course, the government couldn’t leave well enough alone and had to instate the 3.8% Net Investment Income (NII) tax that applies to whichever is smaller: your net investment income or the amount by which your modified adjusted gross income exceeds the amounts listed below.
Here are the income thresholds that might make investors subject to this additional tax:
- Single or head of household: $200,000
- Married, filing jointly: $250,000
In other words, if you earn $250,000 in W2 income as a married couple, and then another $100,000 in investment income, you’ll have to pay an additional $3,800 in NII tax on top of a 15% long-term capital gains tax rate in addition to your state income tax, if any.
Given the NII tax thresholds, I’ve argued the ideal income for maximum happiness is $200,000 for singles and $250,000 for married couples.
How To Minimize Capital Gains Tax
Savvy people will point out that even though long-term capital gains tax rates are more favorable, they are essentially a double taxation on money that was already taxed. Therefore, I wouldn’t get too excited about paying lower tax rates.
What you should get excited about is not having to pay as high a tax rate while not having to actively work for your income if you generate enough passive income. Here are some ways to minimize capital gains tax.
1) Hold forever. The best strategy for minimizing capital gains tax is to hold onto your assets forever, Warren Buffet style. If you can’t hold on forever, then try and hold on for at least one year so your investments will qualify for the long-term capital gains tax rate.
During your decision to hold or sell, it’s very important to calculate the tax implication between your short-term and long-term tax rate. Although it’s generally better to buy and hold for the long-term, when you’re younger or in a lower income tax bracket, taxes are less of a drag on your returns.
As you get wealthier, you become much more incentivized to hold. Think about the single person making $800,000 a year. If he takes a short-term profit on a $200,000 gain, he’ll pay a whopping 37% short-term capital gains tax versus only 20% if he held for at least a year. In other words, the only logical reason for him to sell is if he felt his investment would lose more than 17% or more than $34,000 in value if he didn’t sell within a year.
Just make sure you are holding onto your investments for the right reasons. In my case, the pain of owning my SF rental property outweighed the cash flow it provided, even though my original plan was to hold the property forever. With a 2.5% cap rate versus now a 3.25% risk-free rate of return on 10-year US treasury bond, I’m glad I simplified life.
2) Use tax-advantaged accounts. These include the 401(k), IRA, Roth IRA, SEP IRA, Solo 401(k), and 529 college savings plan. These plans either allow investments to grow tax-free or tax-deferred. Qualified distributions from Roth IRAs and 529 plans are tax-free; in other words, you don’t pay any taxes on investment earnings. With traditional IRAs and 401(k)s, you’ll pay taxes when you take distributions from the accounts.
3) Rebalance with dividends. Rather than reinvest dividends in the investment that paid them, use the dividends to invest in underweighted investments. Typically, you’d rebalance by selling the securities that are doing well and putting the proceeds into those securities that are underperforming. But by using dividends to invest in underperforming assets, you can avoid selling strong performers and the capital gains tax that goes with selling. Rebalancing with dividends will just take longer.
4) Carry losses over. When it comes to capital gains on stocks and bonds, you can use investment capital losses to offset gains. For example, if you sold a stock for a $20,000 profit this year and sold another at a $15,000 loss, you’ll be taxed on capital gains of $5,000. This difference is called your “net capital gain.” If your losses exceed your gains, you can deduct the difference on your tax return, up to $3,000 per year.
5) Look into a robo-advisor. Robo-advisors like Wealthfront are online services that manage your investments for you automatically. They often deploy tax-loss harvesting each month or year which involves the selling of losing investments to offset the gains from winners. To do tax-loss harvesting manually could be very cumbersome, especially if you have a lot of trades.
Action Item For All To Strive For
Everybody should figure out how to generate at least $38,600 in annual passive income if you are single or $77,200 in annual passive income if you are married given the income is all capital gains tax free. At a 4% rate of return, we’re talking about having $965,000 and $1,939,000 in after-tax capital, respectively.
For simplicity’s sake, let’s just round these figures up to $1 million for individuals and $2 million for couples. Once you get to these minimum amounts, depending on your relationship and living situation, you should be able to reach a minimal level of financial freedom.
As one reader put it, the sweet spot is to hold enough bonds (non-tax exempt) to use up the $24,000 standard deduction with the interest income if you’re married, and then generate $77,200 in dividends or long-term capital gains from equities. You’ll make $101,200 of income and not pay any federal tax (you will owe state taxes though depending on where you live). If you want to make more tax-free income, then you’ll simply have to buy and hold municipal bonds from your state.
If you are raising a family in a higher cost of living area, then you’ll probably want to accumulate at least $5 million in after-tax investments instead. One of the key expenses I overestimated in my original $200,000 budget chart was the 25% total effective tax rate. It turns out their total effective tax rate is closer to 17% instead, which buys the couple $16,000 more.
The beauty of the long-term capital gains tax rate is that even if you end up generating more income, you still get the first $38,600 or $77,200 in gains tax-free depending if you are single or married. Therefore, to the extent you can generate more, you might as well keep going until you find your optimal level for financial freedom.
Readers, do you think you could comfortably live off $38,600 / $77,200 in tax-free income each year? If so, what are you waiting for?
This article sings to me. I am working on getting our passive, dividend income up as high as possible. It’s fun to be in a position where we are buying things that will help us buy more things. I am of course talking about financial instruments.
I had not considered a robo-advisor, and I need to take a look at that. I also need to verify that we are not getting taxed on that income, but I suspect the tax software I use does it right.
State municiple bonds are also something I am currently looking into. I got some great suggestions in a comment here, when I asked them a question about it.
My goal is about $200,000 in investment income. I’m at about 1/3 of that now, and we will see how the next few years help that along.
I retired at 46 and am going back to college for the first time. My net worth is only about 1.5 mil and I only owe 180k. My passive income from my rentals is around 65k per year. In Orlando that is more than enough to live a very comfortable lifestyle. I liked the article, and it reflects my reality. Life is very good and looking forward to whatever is next in life.
Exchange Funds are another way of delaying capital gains if you have a large chunk of stock that has grown. My wife and I recently used this strategy to diversify our portfolio and delay the taxes until we are considered Florida residents in another 5 years. That way we avoid the 9.85% state income tax of our current residence.
Hi Sam
Thanks for the interesting article
Where is the real estate (rental) income in this scenario if someone have rental properties?
Thanks
Rental property is special b/c it can be shield from income taxes due to amortization, a non-cash expense. Any profits from rental property is treated as short-term income though.
yYou guys are all very financially savvy and I am a novice so bear with me. I listen to your podcast Sam and I appreciate your take on things. I am learning a lot but have a lot to learn. I have a question: I am selling an investment property and it will have a long term capital gains but I have a loss carry forward that hasn’t been used yet so we are going to use it against this sale. My question is: where do I safely save the cash until I am ready to purchase my next primary residence? We want to probably buy in a year but maybe less than a year if we score a deal in our (expensive coastal) neighborhood.
I would suggest a high interest savings account in an internet bank like ally bank at 1.9%. Although there is a maximum amount u can save in each of the accounts, ~200-250k. A lit of these banks have no issues with quick withdrawals.
I believe Vanguard does not have a limit on the Money Market max and it is at 2%+ with easy add and withdrawal.
Thanks for the Vanguard advice!!
Check out Treasury Direct
The math is eye opening isn’t it? Our tax system clearly favors early retirees.
The sweet spot is to hold enough bonds (non tax exempt) to use up the $24,000 standard deduction with the interest income and then generate $77,200 in dividends or LT capital gains from equities. You’ll make 100k of income and not pay any federal tax (you will owe state taxes though depending on where you live).
God bless America!
Great addition! And if you want to make more tax-free income, just buy and hold municipal bonds from your state.
sorry, but would the higher income from the muni’s raise your AGI and bump you out of the lower bracket?
Good question. I don’t think so because muni bond income is exempt from state and federal taxes, so the income it generates should count as part of your long term capital gains. I’ll double check.
I have a question…Let’s say I have one stock and earn dividend of $38,600 every year. I finally decide to sell the stock because it’s high and let’s say I make $300,000 in capital gain. Are you saying I don’t have to pay any tax on the $300,000 because my income is $38,600? I’m single and I’m in CA.
Thanks
No. You have to pay tax as the numbers are based off total income.
If all your income is from a $300,000 long-term capital gain, then you would pay a 15% marginal capital gains tax rate + a 3.8% tax on gains above $200K/$250K + any marginal state income tax.
If you have active income of let’s say $1,000,000, your $1,000,000 will face a 37% federal marginal income tax rate and your $300,000 will face a 20% LT capital gains tax rate + +.
For the first two tables on the long term gains tax and your income bracket, is that bracket your total income on your w2 for the year or your adjusted income after your deductions? I’ve had people tell me it’s one and not the other and then vice versa. Thanks!
Aren’t the gains rate brackets based on all income, not just the capital gains themselves?
Good point to clarify. I was looking at the long-term capital gains tax rate from an early retirement point of you with no active income.
Active income is taxed as short-term income. LT capital gains tax kicks in on capital gains income, but the active income portion lowers the level in whichever LT capital gains starts.
Eg. if you have $0 active income + $30,000 LT gains, you pay 0% LT capital gains tax. If you have $1M active income + $30,000 LT capital gains, you pay 20% LT gains tax + state + 3.8% NII.
Great post Sam.
Rookie questions: If you had $20,000 active income after deductions, and $20,000 capital gains, would you pay $0 on the active income, and 15% of ($40,000 – $38,700)? i.e. 1) are you still only paying the marginal rate for capital gains, and 2) is the threshold at which your marginal rate is calculated based on LT capital gains alone, or is it based on the sum of LT capital gains and your active income?
Along those lines, would it make sense for someone who is, say, transitioning between jobs and taking an entire calendar year off from work, and who has $35,000 in capital gains that she could realize in that year, to “realize” those capital gains during such a year, even if she intended to immediately reinvest but subsequently with a higher cost basis and a (hopefully) lower tax burden down the road?
For the past three years, Mrs. Groovy and I have had annual living expenses of $36K. We have a substantial capital gain in our one lone stock holding (a lithium mine), but the gain isn’t big enough to offset the loss of our Obamacare subsidy. Our Obamacare subsidy in 2018 is $27K. To have an effective capital gain tax in the 15% vicinity, my capital gain on our lithium stock would have to be somewhere in the low two hundred thousands. We’re not there yet. Perhaps in a couple years. C’mon electric cars!
Capital gains is a pita. I’m trying the hold forever option 1 and option 2 as much as possible. I used to have some turnover in my stock accounts with both gains and some losses but lately I’ve been trying not to have any sales to keep holding and avoid cap gains taxes. Great read!
I am looking forward to having the problem of figuring out what to do with my future mountain of long term capital gains. As a member of a young high earning couple, with positive cash flow (after all our savings, expenses of daily living and taxes) from our jobs, I am interested in getting the forum’s thoughts about using appreciated assets as collateral for loans to make further investments.
For example, say I have a long held index fund with 250k in unrealized cap gains yielding 4%. Rather than paying ~24% in capital gains tax, why not borrow 50k (assume borrowing cost 5-6%/year ) using stock portfolio as collateral and put that money to use and use yield from investment and your 4% dividend yield to service the debt and continue to grow your net worth without taking the tax hit? Your existing dividend income could service a loan up to 20% interest rate or >50% drop in value of index before you’d need to use outside funds to service the 50k of debt, which you have hopefully put to use in a productive investment that will generate income and hopefully appreciate as well.
-ECS
In the coming years, I plan to take advantage of passive income sources to have a lower tax rate on my income. The differential between the highest marginal tax rate (37%) and passive income tax rate (23.8%) provides a strong incentive.
In addition, passive income has money come to you while you’re doing other activities. That’s the kind of money you want giving your financial situation a tailwind. You want your investments to make you money while you’re not thinking about them.
Right now, we’re looking for more liquidity and certainty because we’re accumulating money for a home down payment. Passive income is the long-term goal and right now comes from our investments in Lending Club, my first rental real estate property (condo), the other side of a double we own, and an AirBnB we have behind our house. Were we not looking to buy a house, I’d be aggressively looking for additional passive income sources due to the tax advantage to ordinary income and the ROI on my time and capital.
What the? I’ve never heard of NII tax before. That’s why I enjoy FS. I learn something new all the time. Yes, $2 million in capital is a good goal to shoot for. That’s more than we spend right now and it’s a good middle-class budget with some headroom.
It’s also referred to as the ACA surtax. Implemented to help pay for the Affordable Care Act (a.k.a. “Obamacare”). I’ve paid it every year it’s been there, so I’m acutely aware.
I also live in a high-tax state. My long-term capital gains (and qualified dividend) tax rates are nearly twice the oft-quoted 15%.
But… I am confident I can live in the 0% capital gains bracket comfortably once I stop earning money. There may be some years in which I do Roth coversions, but once that’s done, I should have no trouble keeping TAXABLE income low enough, even with a six-figure annual spend.
Cheers!
-PoF
Preferential tax treatment is one of the biggest reasons why I love the dividend growth style of investing.
Granted this approach will cause you to miss out on companies like Google and Amazon, but being able to regularly share in business profits makes up for it.
It’ll be a balancing act when I retire rolling 401k to Roth so as not to trigger cap gains on our taxable accounts or very little. 77k is not much.
I plan on supplementing with funds already in our Roth. Even then the question is whether 77k is index adequerly to inflation?
FTF, take a look at your funds that now have Unrealized Long-Term Capital Gains.
How much would you have to redeem, in order to hit $77,200? Exactly.
Now do it again the next year. And the next. And the next…. This strategy is working out amazingly well for Mrs. Ceezy and myself, we feel good about it after decades of paying far more in taxes than we live on. In the meantime, the path is cleared for IRA/401(k)/457b funds to be redeemed after 59.5 at Earned Income rates, and the bottom-of-the-bucket is lowered for taxation up to 85% of Social Security.
This assumes I have no other source of income when I’m converting. That’s an assumption I can’t necessarily make though may force.
I actually had a recent post describing my favorite type of money and it was regarding passive income. As you astutely pointed out there is a significant tax arbitrage available between active and passive income (at the highest tax bracket it is 37% vs 23.8%).
That and the fact that I know it is my money working for me rather than the other way around makes mailbox money my favorite type of money.
For those retiring early and have the ability to do a roth ladder conversion (to later minimize RMD) what tax bracket would you go up to to get the best bang for your buck?
I’ve been subscribing the the Warren Buffet method and hope to continue that. If I can leave my investments alone after I fully retire and have enough passive income, then I won’t be double-taxed. Being semi-FIRE has given me the free time to start businesses that I hope will pan out.