AFTER YOU QUIT the workforce and before you start Social Security, you may find yourself with little or no taxable income. As many financial experts have pointed out, this can be a great time to convert a traditional IRA to a Roth and pay taxes at a relatively low rate.
But here’s another tax-savings opportunity to consider: If you have winning stocks and funds in your regular taxable account, this period can also offer the chance to realize long-term gains and pay taxes at a 0% federal rate. The key: Keep your taxable income low, including paying attention to capital gains distributions from your mutual funds. Those distributions may leave you with less room to realize gains at a 0% rate.
How might this work in practice? Let’s take the example of Bob and Jane, a retired couple not yet receiving Social Security. They collect a $30,000 annual pension. In 2020, their taxable investments produced $2,000 in interest, $10,000 in qualified dividends and $10,000 in long-term capital gains fund distributions. Assuming these numbers are the same this year, Bob and Jane would be looking at $52,000 in total income. Result: They could intentionally realize another $53,900 in long-term capital gains, bringing their total income to $105,900—and pay nothing in capital gains taxes.
If they take that $105,900 and subtract a married couple’s $25,100 standard deduction, they would be left with taxable income of $80,800. (The figures for those filing as single individuals would be half these levels.) As long as their total taxable income doesn’t breach that $80,800 threshold, any long-term capital gains—whether distributed by their mutual funds or the result of selling winning investments—would be taxed at 0%.
A key problem: It’s highly unlikely that Bob and Jane’s numbers are going to be the same this year as in 2020, and most can’t be known in advance. Yes, the pension amount is probably fixed, but it’s harder to know precisely how much in interest and dividends they’ll receive during the year, and next to impossible to know what capital gains will be paid out by their mutual funds. Still, they can anticipate 2021’s numbers will be at least somewhat similar to 2020’s, and then finetune their calculations closer to year-end. Here’s what they’ll need to pay attention to:
By waiting until the fourth quarter to realize capitals gains, Bob and Jane can know what their total income and losses from various sources will be for the full year. They’ll then be able to calculate with some precision how much in long-term capital gains they can realize at the 0% tax rate. What if they realize a bit more? The additional gains would be taxed at 15%. This would only apply to those gains over and above the $80,800 taxable-income threshold, so it wouldn’t be the end of the world.
Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. His previous articles were Working My Losses and An Appreciated Gift.
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“and next to impossible to know what capital gains will be paid out by their mutual funds”
Most mutual fund companies post capital gain distribution estimates in November-December for investors to use for tax-planning.
Vanguard (Nov 15 & Dec 9, 2021):
Hence the need to wait until the fourth quarter before transacting to execute the strategy. And, note these are estimates, and can be pretty far off from the actual number, so ideally one would still wait for actual distributions to be made before making their own sales to realize further gains.
It would be interesting to factor in the purchase of Marketplace health insurance (Affordable Care Act health insurance) on this decision (for those pre-age 65).
Assume same facts but what if one of them was received $10,000 in Social Security benefits. If read about the “tax torpedo” but when I use 2020 TurboTax and input this scenario of $10,000 in Social Security (85% is taxable) and reduce the Roth conversion amount by $8500 results in the same federal income tax liability (at the top of the 12% tax bracket.
If you have tax software, you can estimate what your taxable income will be, and get a figure on tax due. Then do the same but add in capital gains, and see what, if any, the difference is.
The $105,900 figure came from a tax table?
It’s the $25,100 standard deduction for a married couple filing jointly in 2021 plus the $80,800 taxable-income threshold below which capital gains are taxed at 0%.
Thank you. This is for federal. I live in a state that taxes cap gains as income without differentiation between long-term and short-term gains. Is the only way to get a handle on the effect for states to get tax software and play with the numbers?
This is a great breakdown of how to work the system in your favor during those pre-social security retirement years…