Do you need more incentive to generate passive income in order to give yourself more freedom? Then look no further than the below two charts. They show the 2023 capital gains tax rates by income for both 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 long-term rate is much lower.
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. However, a divided Congress may make these desires more difficult to pass.
Here are the latest short-term and long-term capital gains tax rates.
Capital Gains Tax Rates By Income For Singles
Most Tax-Efficient Passive Income Amount To Make For Singles
If you're single, the largest tax spread difference between short-term and long-term is if you make between $231,251 to $578,125 in taxable income.
If you make between $231,251 to $578,125 in W2 active income, you are taxed at a 35% marginal rate. However, if you make the same amount in long-term capital gains, you're only paying a 15% rate. In other words, the capital gains tax rate spread is the widest at 20%.
To generate $231,251 to $578,125 you could earn a 4% rate of return on $5,781,275 – $14,453,125 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.
Of course, many argue the long-term capital gains tax rate should be lower since we've already paid taxes on our capital. Either way, the most tax-efficient passive income amount to make if you are single is between $231,251 to $578,125 for 2023.
For the 2023 tax year, you will not need to pay any taxes on qualified dividends as long as you have $44,625 or less of ordinary income (up from $41,675 in 2022).
If you have between $44,626 and $492,300 of ordinary income, then you would pay a long-term capital gains tax rate of 15% on qualified dividends. The long-term capital gains tax rate for single filers with taxable income of $492,300 or more is 20%.
Capital Gains Tax Rates By Income For Married Couples
Most Tax-Efficient Passive Income Amount To Make For Married Couples
If you're married and file jointly, the largest tax spread difference between short-term and long-term is if you two make between $462,501 to $693,750. The tax rate difference is also 20% (35% vs 15%).
Therefore, the most tax-efficient passive income amount to make for married couples is also between $462,501 to $693,750 for 2023.
Obviously, few couples will generate such large long-term capital gains or passive investment income on a regular basis. At a 4% rate of return, the couple would need $11,562,525 to $17,343,750 in investments to generate $462,501 to $693,750 in passive investment income.
However, one scenario that does could create such large long-term capital gains 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
- Married filing separately — $125,000,
- Qualifying widow(er) with a child — $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.
The student loan forgiveness income threshold of $125,000 per individual and $250,000 per married couple may also be considered the ideal income as well. The idea is to look at what income levels the government deems worth of free money or reduced tax rates.
Long-Term Capital Gains Tax Examples
Please note the ideal passive income figures above are theoretical exercises. For the most tax-efficient income, it would be best if we earned 100% of our total income from passive investment income. This way, we pay the long-term capital gains tax rate.
In reality, most of us will earn both active income and passive income. It is important to understand that these two types of income are taxed at different rents. Further, it is the total of these two income sources to determine how much you pay in long-term capital gains tax.
Long-Term Capital Gains Tax Example #1
Say you bought ABC stock on March 1, 2010, for $10,000. On May 1, 2022, you sold all the stock for $20,000 (after selling expenses). You now have a $10,000 capital gain ($20,000 – 10,000 = $10,000).
If you’re single and your income was $65,000 for 2022, you would be in the 15 percent capital gains tax bracket. In this example, that means you pay $1,500 in capital gains tax ($10,000 X 15 percent = $1,500). That amount is in addition to the tax on your ordinary income.
In other words, even if there is a 0% long-term capital gains tax rate on up to $44,625 in long-term capital gains, you still have to pay a long-term capital gains tax on your $10,000 capital gains.
Long-Term Capital Gains Tax Example #2
Financial Samurai Jeff earned $35,000 in 2022. He pays 10% on the first $10,275 income and 12% on the income he earned beyond that, up to $41,775 (35,000 – $10,275 = $24,725). His total tax liability is $3,994.50 ($1027.50 + $2,967).
If Jeff sells an asset that produced a short-term capital gain of $1,000, then his tax liability rises by another $120 (i.e., 12% x $1,000). However, if Joe waited one year and a day to sell, then he pays 0% on the capital gain.
Hence, before selling any investment held under one year, please calculate the net proceeds after tax considerations. Investments held under one year will be taxed at the short-term capital gains tax rates.
Long-Term Capital Gains Tax Example #3
Financial Samurai readers Claire and Hank, who are married, earn a top 0.1% income of $2,000,000 in 2023. They pay a 37% marginal income tax rate on all income above $693,750 until $2,000,000. They pay the other marginal income tax rates on all income below $693,750.
Claire and Hank also have long-term capital gains of $88,000 from selling stock in 2023. Do they get to pay 0% long-term capital gains on the $40,000 since it is below the $89,250 threshold for 0% long-term capital gains tax for married couples? Unfortunately, no.
Given Claire and Hank are in the highest income tax bracket (37% marginal income tax on income over $693,750), their $88,000 will get taxed at a 20% long-term capital gains tax rate.
The IRS wants its money. The IRS isn't going to let an already top 1% income-earning household then earn tax-free income on up to $89,250 for married couples. If so, that would be an obvious loophole every six-figure or top 1% income-earner would pursue!
You have to total the ordinary income and capital gains and then pay the respective capital gains taxes accordingly. Your ordinary income is taxed first, then your capital gains is taxed taxed second.
How To Minimize Capital Gains Tax
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.
We've discussed the difference between active and passive income to avoid confusion. We've also discussed the best combination between active and passive income to live the ideal lifestyle.
Now let's discuss some ways to minimize capital gains tax.
1) Hold forever your asset forever like a billionaire
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. It's generally better to buy and hold for the long-term. But, when you're young 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. Be like a billionaire and never sell your assets and borrow from them instead.
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.
2) Max out 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 instead of selling assets
Rather than reinvest dividends in the investments that paid them, use the dividends to invest in underweighted investments. Typically, you’d rebalance by selling the securities that now take up a higher percentage weighting than your target. You would then reinvest the proceeds into those securities that have a lower percentage weighting than your target.
But by using dividends to invest in underweight assets, you can avoid selling strong performers and the capital gains tax that goes with selling. Rebalancing with dividends will just take longer to get to your ideal asset allocation.
4) Carry losses over
When it comes to capital gains on stocks and bonds, you can use investment capital losses to offset gains. Here's an example. Let's say you sold a stock for a $20,000 profit this year and sold another at a $15,000 loss. You'd 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.
Minimum Passive Income And Invested Capital Targets
For those just getting started, minimum targets are helpful to stay motivated.
If you are single, your goal should be to generate at least $44,625 in annual passive income. If you are married, your goal should be to earn $89,250 in annual passive income.
Why? Because at these passive investment income levels, all the capital gains are tax free! At a 4% rate of return, we're talking about having $1,115,625 and $2,231,250 in invested capital, respectively.
For simplicity's sake, let's just round these figures to $1 million for individuals and $2 million for couples. Once you get to these passive investment income amounts, depending on your relationship and living situation, you should be able to reach a minimal level of financial freedom.
Know The Standard Deduction Levels For More Tax-Free Income
If you want to make more than $44,625 for singles and $89,250 for married couples, here's the next passive income strategy to consider.
For 2023, the standard deduction increases by $900 to $13,850 for singles and by $1,800 to $27,700 for married couples. The standard deduction limit will generally go up every year.
Hence, hold enough bonds (non-tax exempt) to use up the $13,850 / $27,700 standard deduction with the interest income, and then generate $44,625 / $89,250 in dividends or long-term capital gains from equities or other investments.
The single person will make $58,475 and the married couple will make $116,950 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 According To Your Cost Of Living
$1 million to $2 million in invested capital to earn tax-free capital gains may not be enough. If you are raising a family in a higher cost of living area, then you may want to accumulate at least $5 million in after-tax investments instead. Do the math.
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 $44,625 or $89,250 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. For most investors, paying a 15% – 20% long-term capital gains tax rate is reasonable.
Our Passive Income Target Compared To The Ideal
Upon writing this post, I realize our long-term passive investment income target of $400,000 is still below the $462,501 to $693,750 ideal income range for married couples. This range is where the tax rate difference between active income and passive income is largest at 20% (35% vs. 15%).
Therefore, I guess I should work harder to accumulate another ~$1,600,000 in capital! But I'm not going to because I'm tired as hell. We already live on less than the ideal tax-efficient passive income range above.
Take these ideal passive income and invested capital targets as guides. They will help you think about how much to work, how much to relax, and how to construct your total income composition.
At the end of the day, you want to feel fairly taxed for the income you earn. The government also wants you to stay motivated to work. Otherwise, society would collapse if all us sat around and depended on others to pay for everything.
Earning tax-free long term capital gains of $44,625 for singles and $89,250 for married couples seems generous. So does earning tax-free active income of $13,850 for singles and $27,700 for married couples. I'd shoot for these income targets and then reassess.
Personally, it has felt wonderful to take things down this year. A bear market in 2022 and the potential for higher tax rates make grinding less appealing.
For those of you who are tired, take a load off! Analyze your income composition and adjust your effort accordingly.
Are you adjusting your work hours and income composition based on short-term and long-term capital gains tax rates? What do you think of the current tax rates and standard deduction levels? Will you be taking it easier if tax rates go higher?
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