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?