If you need more incentive to generate passive income in order to give yourselves more freedom, then look no further than the below two charts. It shows the capital gains tax rates by income – short-term and long-term.
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. The rate is much lower.
Here are the short-term and long-term capital gains tax rates for 2021 and beyond. Please be aware that President Biden wants to raise the highest marginal income tax rate, the corporate tax rate, and potentially long-term capital gains tax rates.
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. Or, you could earn qualified dividends at the same rate with the same amount of capital. Or you can take profits on long-term holdings. There are many ways to make a 4% rate of return.
For the 2021 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
The 3.8% Net Investment Income (NII) tax is an additional tax. It 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, the ideal income for maximum happiness is $200,000 for singles. For married couples, the ideal income is roughly $250,000, depending on where you live.
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 your asset forever.
The best strategy for minimizing capital gains tax is to hold onto your assets forever. If you can’t hold on forever, then try and hold on for at least one year. After one year, 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. If he held for more than one year, he would only pay 20%.
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. I sold and invested a third of the proceeds in stocks, a third in bonds, and a third in real estate crowdfunding.
As a father of two young children, I don’t have the time to deal with tenants anymore. My kids are growing up fast. I don’t want to miss a thing.
Earning income passively through real estate platforms like Fundrise has been nice so far. The income is steady and the asset isn’t volatile, unlike stocks. Fundrise is free to sign up and explore. I’ve personally invested $810,000 in real estate crowdfunding to diversify away from my SF real estate holdings.
2) Use tax-advantaged accounts.
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. You would then reinvest 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 for tax-loss harvesting.
Robo-advisors like Personal Capital are online services that manage your investments for you automatically. It deploys tax-loss harvesting, 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. Therefore, using a robs-advisor to automate can be very helpful.
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.
Adjust Your Income Accordingly
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.
With Joe Biden as President, expect to see income tax rates go up for households making over $400,000 a year. As a result, the short-term capital gains tax rate will go up for households in this category as well.
Personally, I’m looking to take things down a notch during the Biden Presidency. We’ve had a fantastic run in the stock market and real estate market. I’m tired from the pandemic and really want to spend more of my gains and catch up on life.
Besides, there could very well be a long-term capital gains tax hike as well. With income taxes and capital gains taxes going up, if you are exhausted, it’s probably best to take things down a notch and enjoy life more.
Track Your Wealth Carefully
Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances.
In addition to better money oversight, run your investments through their award-winning Investment Checkup tool. I will show you exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their Retirement Planning calculator. It pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. Definitely run your numbers to see how you’re doing.
I’ve been using Personal Capital since 2012. In this time, I have seen my net worth skyrocket thanks to better money management.
Invest In Real Estate For Passive Income
If you’re tired like me and interested in a hands off approach to real estate investing, consider investing in a publicly traded REIT or in real estate crowdfunding. Once I had my son in 2017, I decided to sell my PITA rental house and reinvest $550,000 of the proceeds into real estate crowdfunding. My favorite two real estate crowdfunding platforms are:
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eREITs. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. For most investors, investing in a diversified eREIT is the way to go.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends. If you have a lot of capital, you can use CrowdStreet to build your own select real estate fund.
Both platforms are free to sign up and explore.