For people who retire in their 30s, there is a long stretch ahead before we can access our retirement accounts at age 59.5.
For ourselves, and many others, the solution is a sufficiently large taxable brokerage account to fund life for several decades. The long term, if you will.
But over time, this can become increasingly tax inefficient.
Compound Interest
In the dream scenario, the years of retirement see economic prosperity for all and a stock market that trends upward with no end in sight. Or in other words, more of what we have seen for the past 200 years or so.
We’ve all seen those great charts that go up and Up and UP! In fact, here is one that I found on multpl.com. Over the long term the market has returned ~9% per year, roughly 50/50 dividends / capital gains.
We are spending our dividends as we go, so with 4.5% capital growth only, over the next 25 years we could see a nice 200% gain / 3X return on our investments.
Compound interest is a beautiful thing.
Spending Money
In the early years of retirement, we can sell some stock when we want some spending money. If we sell $10,000 worth of stock that has appreciated 5%, we will have a taxable $476 (long-term) capital gain (likely with a tax rate of 0% at the Federal level.) The remaining $9,524 is just the money we bought the stock with originally.
Fast forward 20 years or so and that same stock sale generates a taxable capital gain of $6,667. Only $3,333 is a non-taxable return of basis.
It is pretty fascinating to see how normal long term growth changes what percentage of equity sales are gain vs return of basis, so much so that I made a chart :)
Due to the generous nature of the Federal tax code, this may only impact payments to the IRS for the really big spenders. But for people in States with an income tax and/or enrolled in ACA health insurance, this can be substantial.
With ACA premiums as much as 3X higher for Seniors, if greater realized capital gains push a household over the ACA subsidy cliff the effective tax rate could be massive. (A Roth IRA to bridge the gap before Medicare can help insure staying on the beneficial side of the subsidy cliff.) (Other MAGI based benefits may also be impacted, e.g. FAFSA / education assistance.)
Harvesting Capital Gains
To minimize long term long-term capital gains, we can employ a sustained multi-year effort to harvest capital gains. Again, State and ACA subsidy taxes may apply.
Over the past 5 years the S&P500 increased 87%. As the markets rose, we harvested $147,207 worth of gains while paying $0 in tax.
With an 87% gain, a stock sale would consist of 47% capital gain ($4,650 of a $10k sale, from the chart.) Because we raised our basis through harvesting, we can sell stock with only a 25% gain. This means only 20% of a sale is a capital gain ($2,000 of a $10k sale, also from the chart.)
Assuming a 15% capital gain tax rate and a 15% ACA subsidy reduction, this alone would be a tax savings of ~$800, and I can always harvest more next year. Not bad for just a few minutes of my time once per year.
If you don’t already have it, you can get my capital gain harvesting template based on the trades I executed in Dec 2016. Fill out this form and I’ll email it to you.
Summary
Over the long term, due to the wonderful force of compound interest we will likely end up with a large amount of capital gains. If/when those gains are realized, we may be taxed or have ACA subsidies reduced. This impact increases with time.
As an example: On a $10k stock sale, with 5% growth we have only a $476 capital gain. With 100% gain we have a $5,000 capital gain. If this gain was taxed at 15%, the difference is a tax of $71 vs $750.
To minimize the tax impact of long term long-term capital gains, we can employ a sustained multi-year effort to harvest capital gains, which effectively increase our basis. This can be done tax free if NOT using ACA health insurance and not in a State with an income tax. Or outside the US.
Hi GCC! Long time reader – first time writer –
Tag Gain Harvesting – I haven’t seen any new articles come out since the US tax code update. Is it still true that you must be within a specific earned income marginal tax bracket in order to pay 0% federal tax on capital gains (up to a specific amount)? Or does your earned income marginal tax bracket not matter at all when it comes to staying within the 0% tax rate for long term capital gains?
Thanks!!!
Jorge — You still think of long-term cap gains as sitting at the top of your income stack. It used to be that the threshold where ltcg started getting taxed at 15% instead of 0% was exactly at the border between 15% and 25% tax bracket.
The tax reform changed it to a specific dollar amount, but it’s within a few hundred $ of the border between the new 12% and 22% brackets. The dollar value will adjust with inflation.
Example: Single taxpayer could have 12000 standard deduction plus 38600 of taxable income, i.e. 50600 of income plus gains and not have ltcg tax.
As before, if some if your ltcg sit below that 38600 and some sit above, the first chunk is taxed at 0% and only the second chunk is taxed at 15%. There is a Qual Div and Cap Gain Tax worksheet in the Form 1040 instructions booklet that does this math.
We haven’t been able to harvest those capital gains yet. We make too much income. Once Mrs. RB40 retires, we can sell some stocks and work on optimizing taxes. We’ll have to see how the tax code change impact our situation too. It’s pretty complicated. I’m pretty sure we will have to pay more taxes in 2018 because our income increased a bit. Also, the SALT cap really sucks for us.
Gotta move out of Oregon first…
Yup I moved to WA with no state income tax…
We’re planning on doing a big chunk of gains harvesting this year. I think it’s going to cost us a bit of ACA premium tax credit when we settle up at tax time but the “repayment” required is limited (or at least I think that’s how it works!). State taxes will cost us a couple of arms and legs.
But part of the purpose of CG harvesting is to increase our basis so that when college costs hit in a few more years, we have some assets with a very high cost basis. We’ll be managing AGI for FAFSA purposes too.
The limited part, I believe, is in relation to the CSRs. You’ll have to shore up the PTCs.
FAFSA and ACA are my two reasons for wanting to get to high basis. I’ll be around age 59.5 when Jr hits college age, so will have full access to Roths.
RoG — Repayment limitation only happens if your final household income is under 400% FPL, and your MAGI includes your cap gains even if they are taxed at 0%. So if you are strategically realizing cap gains to reset basis, keep this in mind.
Source: Table 5 in Form 8962 instructions.
https://www.irs.gov/instructions/i8962#idm140719954222560
I’ve been advised to max out the 12% bracket with Roth conversions for the next 7 years until age 70 (when I will begin to collect social security) to minimize RMDs and taxation of my social security. How do I weigh doing Roth conversions against harvesting ltcg (of which I currently have about $80k I think)? Thanks.
Look at the math.
You are probably being advised to pay tax now at 12% so you won’t later pay it at 22%+. Be careful you aren’t going over the ACA premium subsidy cliff before Medicare.
Cap gain harvesting is a 1-time thing; all future growth is still taxable. Future gains on Roth conversions are also tax free.
Tax rates on cap gains are 15% – 20%. (Maybe 23.8%.) Compare to 22%, 24%, 32% from RMD.
We have been doing a bit of selling parts of positions in taxable accounts and rebuying them reducing the tax bit later.
We also have been working low stress, low(ish) pay part time jobs this year to reduce the need to sell stock. This should also yield us EITC and refundable CTC. We did have to horde cash in 2017 to make it work. Two months to go still seems to be on track to work.
Solid plan, especially if those part-time jobs offer health insurance.
Seems like a pretty smart strategy. Unfortunately our income is way too high to take advantage of this now, but maybe someday in the near future.
Good post! Thanks!
It’s tough to give up ACA subsidies to implement cap gain harvesting and Roth conversions. It’s tempting to spend the shares with highest cost basis now to get more ACA subsidy and small Roth conversion room today. I sometimes think I should alternate years maximizing ACA subsidies with maximizing Roth conversion and/or cap gain harvesting, if no reason other than to make me feel better that I’m at least partially taking advantage of all these strategies. Sequence of return risk also has me leery with spending more tax (receiving no subsidy) today.
It’s a complex trade off. One could alternate by enrolling in a cheap / low coverage plan in Year 1 and doing Roth conversions / cap gain harvesting, and then in Year 2 enroll in an expensive / high coverage plan but high subsidies (<200% FPL income) in Year 2. Plan for all surgeries, births, major issues in Year 2. This would work best for the young and healthy with low risk of accident. Probably easier to just go abroad for a few years...
When we add to our donor advised fund, I donate the lots with the highest percentage of unrealized capital gains. Another strategy we may very well employ is to some day pass some funds on to our kids. The cost basis is reset (or “stepped up”) to current value, so any accumulated potential capital gains tax is eliminated.
I may be able to take advantage of tax gain harvesting in retirement, assuming there is room to add some taxable income while staying in the 0% LTCG bracket. We’ll probably do some low-cost Roth conversions first.
Cheers!
-PoF
It’s these types of articles that I like most about GCC. Kept it up!
Thank you, sir.
Something of interest – it appears that nonresident aliens are not subject to US capital gains. Per https://www.investopedia.com/ask/answers/06/nonusresidenttax.asp
“Capital Gains
In terms of capital gains, nonresident aliens are subject to no U.S. capital gains tax, and no money will be withheld by the brokerage firm. This does not mean, however, that you can trade tax free. You will likely need to pay capital gains tax in your country of origin.”
‘Likely’ being the operative word… some countries (e.g. New Zealand) have no capital gains tax.
For a US citizen, this obviously isn’t a solution (unless renunciation of US citizenship is something you would consider), but for foreign citizens currently in the US and putting post-tax savings into a brokerage (like myself), it may be an option for increasing basis substantially. Now that would truly be harvesting MASSIVE capital gains!
Nonresidents do pay tax on dividends, however.
For a household like ours (US citizen married to non-citizen), technically I could gift appreciated assets to my spouse ($150k/year if I’m remembering correctly) and she could sell them with no capital gains tax if we filed US taxes as married filing separately. If you are in a country with no taxes or no capital-gains taxes, this is a zero tax event. After a few years of this… you could be at 100% basis.
Hello Jeremy,
If you lived in a sate such as California where long term capital gain is taxed as regular income, is there anyway to avoid long term capital gain being taxed at the marginal tax rate brackets between 1% to 13.3%? or are we just stuck paying for this?
No way to avoid, just pay the tax