Even individuals with significant assets may qualify for the zero percent federal tax rate on capital gains and dividends. Many retirees encounter a window of years where, in spite of having significant wealth, they’re able to keep their taxable income low while generating cash flow from their portfolio. Typically this occurs after an individual retires but before they begin receiving social security and before they begin complying with the required minimum distribution rules that require IRA distributions for individuals over the age of 70½.
Here is an example. This client has the following circumstances:
Married, filing joint returns. Is under the age of 70½
Retired but has not begun drawing on social security
$1,000,000 in tax-exempt bonds generating coupons of $35,000 per year
$2,000,000 in a tax-managed stock portfolio
This stock portfolio generates $40,000 in qualified dividends
This stock portfolio has cost basis of 40% and unrealized gain of 60%. Thus, for every dollar raised, 60 cents is capital gain. (This assumes the portfolio manager has no “low hanging fruit” or losses to harvest.)
$2,000,000 held in an IRA in a diversified stock and bond portfolio
Needs $175,000/year in cash flow
Receives $35,000 tax exempt bond interest
Receives $40,000 in dividends
Raises the balance needed – $100,000 – with a capital gain of $60,000 (60% of 100k)
Itemized deductions total $27,000 including
Property taxes of $10,500
State taxes of $4,500
Charitable gifts of $12,000
We find it remarkable that, in spite of having a liquid net worth of $5,000,000 and spendable cash flow of $175,000, this couple will not pay any federal tax for this calendar year. This is because their taxable income will be below $75,300 – the threshold above which dividends and capital gains become taxable at 15% but below which they enjoy a 0% tax rate. Take note, they will owe state taxes of approximately $4,500 on the gains and dividends, as states do not differentiate between income sources. (Note that the estimated state taxes will need to be paid during the year so that they can be deducted in April.)
When income from social security and IRA distributions come into the picture at a later date, the window for the zero rate will close barring large deductions which, more than likely, would require significant charitable gifts.
We put this topic in the category of “Paying Attention to the Details” for our clients. Sometimes we even harvest gains opportunistically even when the cash proceeds will not be needed until future years. Yes, we will consider this strategy when deciding whether to convert some of a client’s IRA to a Roth or when advising them when to start drawing Social Security. We will also pay attention to what we own and where we own it, avoiding non-qualified dividends and inadvertent gain distributions from actively-traded mutual funds in after-tax accounts. Such investments, we instead “stack” in the tax-deferred IRA account, a strategy we call asset location. Read more here about Asset Location for Tax Efficiency. In all cases we will coordinate our efforts with your tax advisor.
Please call us if you would like us to help you explore opportunities like this for you.
This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.