YOU WOULDN’T WANT to spend your entire life in the 0% tax bracket, but it’s a nice place to visit. Got stocks or stock funds in your taxable account? If you sell them in the right year, you could realize capital gains of almost $100,000 and perhaps more—and pay a 0% federal capital gains rate.
I was reminded of this loophole as I was flipping through Phil DeMuth’s latest book, The Overtaxed Investor, an amusing and easy read—not words often used to describe a tome on taxes.
Let’s say you’re out of work or you just retired and haven’t yet claimed Social Security. As things stand, you don’t expect any taxable income in the current year. To take advantage of the situation, you might convert a portion of your traditional IRA to a Roth. Part of the conversion won’t be taxed, thanks to your personal exemption and your standard or itemized deduction. But if you convert more than a modest sum, you’ll owe at least some income taxes. Nonetheless, that tax bill may be a small price to pay to get the money into a Roth, where it’ll grow tax-free thereafter.
But here’s an alternative way to exploit your low-tax year: You might sell stocks or stock funds in your taxable account that have unrealized capital gains. This isn’t worth doing if you’re happy with the holdings and plan to hang on to them until you die, at which point the embedded capital gains tax bill will disappear, thanks to the so-called step up in basis. But if you aren’t happy with the stocks or stock funds, or you know you’ll have to sell eventually, this could be the chance of a lifetime.
How so? In 2016, if you’re single and you claim the standard deduction, you could have income of as much as $48,000 and stay within the 15% federal income tax bracket. If you’re married filing jointly, the threshold would be twice as high—$96,000. Itemize your deductions? These figures may be higher still. The beauty of this tax situation: If your total income stays within these limits, any income would be taxed at 15% or less—but your long-term capital gains would be dunned at 0%. That isn’t a typo. Keep in mind that, to qualify for this 0% rate, you have to hold your stocks or stock funds for more than a year.
To be sure, there could be some tax cost involved. For instance, depending on your total income, you might have to pay taxes on your Social Security benefit, you could lose various tax credits and you might have to pay state income taxes. Still, the tax hit will likely be fairly modest—and the benefit substantial.