How to Realize Tax-Free Earnings on Your Investments
When you’re in the zero percent tax bracket, capital gains can lead to significant net gains on your assets. Recognizing gains at 0% isn’t difficult, but it does take some serious planning to realize the full benefits. By intentionally selling an investment in a year when any gain won’t be taxed (i.e. when you’re in the 0% capital gains tax bracket), you can avoid taking a hit and maximize your potential earnings.
Here are some things you should know to make the most of this savvy financial strategy.
Understanding the 0% Long-Term Capital Gains Rate
The 0% long-term capital gains tax rate has been around since 2008, and in the tax year 2021, the 0% tax rate on capital gains applied to a specific group. That year, married taxpayers who file jointly with taxable incomes up to $80,800, and single tax filers with taxable incomes up to $40,400, were eligible.
Short-term vs. Long-term Gains
Before you can reap the benefits, it’s critical to understand the difference between “short-term” and “long-term” capital gains. Short-term capital gains apply to any investment that you bought and sold recently, within a 12-month timespan. For example, if you buy stock today at $1,000 and sell it six months later for $5,000, it would have a $4,000 short-term capital gain. Short-term capital gains are taxed as ordinary income, just like your paycheck, and the 0% tax strategy does not apply.
Long-term capital gains, however, are a great opportunity to realize a profit. Say you bought the same stock at $1,000, and three years later sold it for $5,000. That would be a good strategy for recognizing gains at 0% if you fit the criteria. And it doesn’t have to be stock—your investment could be a business, investment property, or another asset. When you sell these at a profit and you have satisfied the one-year holding period, you could be set up well for making the most of your money.
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Opportunities for Recognizing Gains at 0%
In some years, you could have less taxable income than in others. This doesn’t have to be left up to chance either. You can sometimes make a low-tax year occur on purpose by choosing which accounts you take withdrawals from and planning out an earnings strategy.
Here’s an example: Joe is married and his taxable income this year, calculated after subtracting itemized deductions and the standard deduction, is going to be about $70,000. Joe has roughly $10,400 of room for more income before he hits an ideal long-term capital gains bracket.
If Joe owns stocks or mutual funds in a non-retirement account and some of them have unrealized long-term gains, he has a great opportunity. By exchanging his investment for something similar so his portfolio allocation and risk tolerance stay about the same, Joe could have up to $10,400 of realized gains and pay no income tax on them in a scenario like this.
How to Harvest Great Capital Gains
Being prepared is the first step to reaping the benefits of your capital gains. Here are some tips you should know as you start to plan your next financial steps:
- Make sure to check your return: If you have a capital loss that’s being carried forward from a previous year, any potential gains may take a hit. Past losses can carry forward indefinitely, first to offset gains, and then to offset ordinary income (up to $3,000) if you have no gains that year. Check with a tax professional to make sure you know what you’re dealing with.
- Make mutual funds work for you: At the end of each year, mutual funds distribute capital gains. How much you’ll see in gains depends largely on the kind of funds you own. If you own tax-managed or index funds, gains will likely be minimal, but if you own funds that aren’t managed with taxes in mind, you could see larger gains.
- Make an educated tax estimate: Working with a tax professional or financial advisor can help ensure you have an accurate estimate of your tax situation for the year. No matter how investment-savvy you are, running multiple scenarios through an online tax preparation software can be a smart way to double-check your figures and cement your planning strategy.
Big Benefits. But What About Potential Pitfalls?
Gain harvesting can be an effective way to realize a tax-free profit, but it’s not always straightforward. A miscalculation could be a costly mistake come tax time, so it’s important to know what to avoid and how to best prepare.
First, you must build a habit of projecting taxes and looking for tax opportunities by the end of each year in order to be successful. If you’re retired, view those years as a chance for hitting that zero percent tax bracket as regularly as possible. That means more of your retirement income will end up in your pocket.
Even with that habit firmly in place, consulting a professional is the best way to avoid potential pitfalls and make sure your lower income years aren’t going to waste. If you’d like to discuss your options with an experienced member of the Resolute staff, reach out to us today. We look forward to hearing from you!