The 0% capital gains tax bracket is one of the most overlooked tax planning opportunities for retirees.
How does it work?
The concept is straightforward, but the planning strategy is counter-intuitive to what most people have in mind when they think "tax planning".
Here are the nuts and bolts of it:
For federal purposes, long-term capital gains are taxed at lower rates than ordinary income. Capital gains are realized anytime you sell a capital asset, such as a stock or bond, for more than your "cost basis", which is typically that amount you paid for it. In order to be taxed at the lower capital gains rates, the investment must have been held for at least one year. If you sell it sooner than that, your gain is taxed at the higher ordinary income tax rates.
The picture below shows capital gains rates for 2022. Importantly, the tax rate is zero percent on capital gains for single taxpayers with income below $41,675 and married taxpayers with income below $83,350.
These income thresholds are for your total taxable income, which means that many households will be bumped into the 15% bracket because of other income reported on their tax return.
But retirees often have lower taxable income, particularly in the early years of retirement before social security, pensions, and Required Minimum Distributions start. Plus, if you have savings built up in a non-qualified or Roth account, you can have a lot of control over how much taxable income is created by your investment portfolio in any given year.
If you are retired and in a low income year, consider intentionally recognizing gains in your investment portfolio to the extent that your total taxable income is projected to be below the zero percent capital gains bracket thresholds. For example, if you're single and your taxable income is projected to be $30,000 for 2022, you could recognize $11,675 in long-term capital gains without paying any federal taxes on the gain.
After you sell a position to realize the gain, you can simply repurchase the same investment so that your overall asset allocation isn't changed at all (or, you could use this as an opportunity to rebalance your portfolio).
So what's the real benefit of this strategy?
By recognizing the gain on your investment (despite paying no federal taxes), your "cost basis" has now been increased to the higher amount at which you sold it. This will allow you to sell the investment in future years while realizing a much smaller capital gain.
Retirees will thank themselves later once social security income and Required Minimum Distributions begin. By that time, their taxable income is much higher, so capital gains are more likely to be taxed at 15%. By having a higher cost basis on positions in your portfolio, you'll be able to liquidate investments without as much tax drag.