FIRE Secret: Tax-free capital gains
Did you know it’s possible to live off tax-free capital gains from your investments if you plan it correctly?
There are several tax secrets most people won’t learn about unless they love hanging out on Reddit /FIRE.
I didn’t know about them while studying Finance in college, but only when we began pursuing our financial independence.
That’s because the majority of financial planning information we learn is how to retire when we’re 65. Invest in your IRA and your 401(k), then someday it will all pay off.
But what if you want to pursue an adventure before you’re 65? Could you survive a couple of years without a salary while you build your business?
There are ways to take money out of retirement accounts, but unless it’s a Roth IRA, you’ll have to pay income taxes and, in most cases, a penalty.
The secret: tax-free capital gains
One of the best secrets to fund an early retirement while minimizing taxes is to sell stocks or funds with significant gains, but staying under the income limit, so you don’t have to pay federal capital gains taxes!
Capital gains taxes are already lower than income taxes for most people, but they’re ZERO percent for anyone making under a certain income each year.
How much can this secret save you?
If you knew Jeff Bezos would take over the world and bought 500 shares of Amazon in 2001 at $10 per share, you’d have $5,000 worth.
Today, those 500 shares would be worth $1,750,000. Holy smokes, why didn’t we all do that.
Anyway, you’d be sitting on $1,745,000 in long term capital gains because your original purchase price was $5,000.
So how do you access this money without getting plowed over with taxes? If you wanted to pull out fifty grand to buy a boat, you could owe between $7,500 and $11,500 in federal taxes plus applicable state taxes.
It’s a small price to pay for such a huge profit, but using this trick could yield the full $50,000 without paying any federal taxes.
Income limits for tax-free capital gains
The secret to harvesting tax-free investments is to stay under a certain income threshold. In 2020, as long as your adjusted gross income (AGI) is within the 12% tax bracket, you won’t pay federal long term capital gains.
Here are the amounts for 2020 you’d have to stay under:
- Single: up to $40,000
- Married filing jointly: $80,000
- Head of household: $53,600
These income limits are pretty low if you’re used to a large income. However, if you have enough saved up and your expenses are low enough, you could plan a year without income and fully capitalize on this option.
How we used this FIRE secret
When we quit our corporate jobs and FIRE’d in 2016 to travel North American in our vintage Airstream, we had enough cash saved to fund our trip.
When our one-year trip turned into three, we needed some additional funds.
Our investments grew quite a bit during this window, so we felt comfortable selling some of them to fund our continued adventures.
Since we didn’t have salaries, the capital gains and dividends were the only income that showed up on our tax return, keeping our long-term capital gains rate at 0%.
Since our address remained in Texas while we were traveling, we didn’t have to pay any state taxes.
How capital gains interact with income tax
If you still have income and you want to use this FIRE secret, you’ll need to plan more diligently as long term capital gains “stack” on top of income.
Your long term capital gains can’t bump you into another tax bracket for income, but since they stack, any amount over the 12% bracket starts getting taxed at the next higher capital gains rate of 15%.
All deductions are applied, which lowers ordinary income, so the stackable amount is lower.
If you’re taking the standard deduction as a single filer, you remove $12,400, and a married filing jointly is $24,800.
You would also remove any additional above the line deductions such as IRA and HSA contributions. Let’s get into an example.
Case Study: Ahmer and Linda
Ahmer and Linda were employed for six months in 2020 but got laid off and now want to take advantage of the time away from their careers by taking the rest of the year off.
They’re big savers and have an investment brokerage account.
Here are their numbers:
- 2020 Income: $65,000
- Standard Deduction: $24,800
- IRA Contributions: $12,000
- HSA Contribution: $7,100
- Adjusted Gross Income: $21,100
Since they both had income this year, they maxed out their IRA’s and HSA contribution, leaving them with an AGI of $21,100.
They’re married and filing jointly, so they can fill up to the 12% tax bracket ($80,000) and not pay any federal long term capital gains taxes!
That’s nearly $60,000 of available capital gains they could skip due to this planning. Here’s an illustration:
Remember, that’s $60k of gains, not just $60k of stock sales.
Long term capital gains tax rates
While capital gains tax rates are much lower than income tax rates, they increase based on income levels. Essentially, there are four tax brackets for capital gains at these levels:
Most websites only highlight three brackets (0%, 15%, 20%), but they fail to mention the net investment income tax of 3.8% that kicks in at the income levels listed above (18.8% tax bracket).
What about state taxes on long term capital gains
You’ve probably noticed I talk about reducing the federal long term capital gains rate to 0%, but not the state rates. That’s because most states tax capital gains at the same rate as your ordinary income.
However, nine states don’t tax long term capital gains (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
The Motley Fool has a great graphic showing the top marginal long term capital gains tax rate for each state.
Other states look at your “stacked” income of ordinary income plus capital gains to determine your tax amount, so make sure you consider this when harvesting your 0% tax rate.
If you will have a large capital gain on a sale in the future and you plan on moving already, it could make sense to wait, especially if you’re moving from a state like California (13.3% max capital gains) to one one of the 0% states.
What else to think about with this FIRE secret
Even though the long term capital gains don’t increase your ordinary income tax rates, they increase your adjusted gross income.
Roth IRA contributions or IRA deductions are based on AGI, so you need to plan carefully.
Additionally, healthcare subsidies are also based on AGI, so your large capital gain could put you over the subsidized income.
In conclusion, if you have the “problem” of having large capital gains, you really should plan out the best way to harvest them and minimize the tax impact.
There are multiple strategies such as the “Gap Year,” “FIRE,” or just retirement where you can maximize your income and minimize your tax impacts. You need to get your plan in place!
