The US tax system vastly favors leisure over labor. It favors people who just own things and sit around and collect rents over people who actually do work for a living.
How is this so?
Because rents and returns on capital assets are taxed WAY more favorably than wages from labor. So favorably, in fact, that you can actually make 6 figures income and pay zero taxes.
For the rest of your life.
This would never be possible with labor wages.
So in this week’s podcast episode, I’ll show you how our tax system is structured in a way that allows you to make over 6-figures in income with zero tax liability.
What you’ll learn in this episode:
- Why and how our tax system creates this opportunity
- What are the scenarios in your life where you can take advantage of this
- Exactly how it works step by step
- And the best way to optimize this loophole
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Links mentioned in this episode:
- IRAs, Roth IRAs, and how to get the tax benefits of BOTH (HYW004)
- How to take a year off, earn 6 figures, harvest capital gains, do Roth conversions…and pay zero taxes on it all (updated for 2020)
- TurboTax TaxCaster
- HYW private Facebook community
Read this episode as a post:
Today I want to talk about capital gains taxes and how our tax system allows you to make over six figures in income with legally zero tax liability.
You’ve heard me mention this a few times in prior episodes, this notion that capital gains and qualified dividends can be taxed at zero percent. And that may seem counterintuitive because you normally often hear about capital gains being taxed at 15% to 20%.
So I want to spend some time in this episode talking about why, in some cases, capital gains and certain dividends can actually be taxed at zero percent, exactly what scenarios that would occur, and exactly how it works. Because under current tax law, there is definitely an opportunity to earn over six figures and have zero tax liability.
I wrote a blog post about this a while back (capital gains harvesting), but I figured it’s a good time to revisit this topic and do a refresh, updated for 2020.
But still, you can get a good lay of the land by checking out that old blog post that I wrote before.
But we’re also going to deep dive today on exactly how that works and how to do it and maybe situations in your life when you might be able to take advantage of this. So you definitely want to stick around for that.
Before we get into all that though, I want to invite you, as always, to join the private Hack Your Wealth Facebook group which you can access at hackyourwealth.com/fb.
I encourage you to join there. It’s a way for us to connect, have a two-way dialogue. I’m in there every single day, often multiple times a day, responding to every question and comment there.
And many folks in the group are asking questions about financial independence, early retirement, tax strategies, real estate investing, side business income, online income, career transitions, or just advice about any personal finance or even career matter that comes to mind.
So it’s a really friendly and great group of people. I encourage you to join and check it out. hackyourwealth.com/fb.
As I mentioned a moment ago, you might be wondering, how is it possible that you can earn over six figures and legally pay no taxes, especially given that according to the Bureau of Labor and Statistics and the U.S. Census, only 5% to 10% of the population earns over $100,000 and less than 20% of households earn that much?
So how is it possible that the tax system actually allows those high earners to pay zero dollars in taxes? Well, it’s not only possible, but plenty of people actually do this.
And if you are thinking about early retirement, then this is tailor-made for you because it especially favors people who have low ordinary income or low earned income, but high investment income.
That’s the key insight here.
Earned income is taxable income and wages that you get from working. It’s basically your labor. That’s wages, salaries, tips, self-employment earnings, some types of disability benefits.
And it is considered ordinary income. It does not include things like interest in dividends, retirement income, social security, unemployment benefits, or alimony and child support.
Investment income, by contrast, is unearned income. It’s a type of unearned income, but it’s not the only type.
Unearned income is income not acquired through work. And that consists of things like inheritances or passive investments.
And it includes all the things that I just mentioned: interest in dividends, capital gains, retirement income, social security, pensions, annuities, unemployment, alimony, child support, plus any debts that are forgiven. All these different types of income are considered unearned income.
And investment income, in particular, it’s not guaranteed, but it’s potentially taxed at different rates, usually lower rates than ordinary income.
And to really get your head around this, we have to understand that there are two parallel tax systems in the U.S.
One for ordinary income, like earned income, salary, wages, everything I just described a moment ago, and one for investment income, like interest, dividends, capital gains, etc.
These two types of income have parallel tax systems.
Now, there is another parallel tax system not to be confused here that sits adjacent to these two, which is the alternative minimum tax system, the AMT system.
But let’s just set that aside for a moment to not confuse the issue and just pretend there is the one and only regular tax regime, a regime that has two parallel systems: one for ordinary income and one for investment income.
These two types of income tax at different rates. And up until a couple of years ago, it used to be that the first type, your ordinary income tax bracket, would determine the second type, your investment income tax bracket.
The two were directly linked. Whatever your ordinary income tax rate was would actually determine whatever your investment income tax rate was.
But beginning in 2018, with the passage of the new tax legislation called the Tax Cuts and Jobs Act, this changed. And now the two are decoupled.
They’re still correlated, but they’re not directly linked anymore. They’re indirectly linked.
So no longer does your tax rate in the ordinary income system determine your tax rate in the investment income system. Instead, your taxable income amount, the literal number of dollars of taxable income you have determines your rate in both systems.
And in each of these two tax systems, there is a threshold where if you earn less than that threshold, you will pay zero dollars in taxes. For the ordinary income tax brackets, the threshold for most people will equal the standard deduction.
In 2020, that means $12,400 for single filers. Double that amount, or $24,800, for married filing joint.
For the investment income tax brackets, also known as the long term capital gains and qualified dividends tax bracket (I know that’s a mouthful), that threshold for Year 2020 is $80,000 of taxable income.
If you earn $80,000 or less of taxable income, you will pay a tax rate for long term capital gains and qualified dividends at a zero percent rate.
Now, I’m just going to quibble here for a moment.
For the ordinary income tax brackets, the standard deduction amount I just mentioned a moment ago as being the threshold where you pay zero dollars in taxes, that isn’t 100% accurate.
If you want to get technical about it, it is possible you could actually earn more and still pay zero dollars in taxes because there are so-called “above the line” adjustments to income, like your retirement account contributions to a 401k. Those get adjusted out and never become part of taxable income.
There are itemized deductions you can take if you have enough of them to exceed the standard deduction amount, maybe because you have a lot of mortgage interest or medical expenses or charitable donations or state and local taxes, things like that.
You also have tax credits, like the child tax credit. That could zero out your tax liability, even if you do owe some taxes.
So there are all these ways that you could technically earn more than the standard deduction amount and still owe zero dollars in taxes. But it all depends on your situation, case by case.
But the mental shortcut way you can think about it is the standard deduction amount is going to be tax-free because that’s the minimum everyone gets just for being alive and a citizen. It doesn’t depend at all on your individual situation.
So everybody gets at least the standard deduction tax-free. And if you earned exactly that amount as the standard deduction, your taxable income would be equal to zero.
That’s under the first tax system for ordinary income for ordinary tax brackets.
Then you move over to the long term capital gains and qualified dividends tax system. That’s the one for investment income. And here you can have up to $80,000 in investment income, that is, taxable income, and zero percent taxes on it.
Again, this is for 2020. The $80,000 threshold is for 2020. That means you could earn over six figures of income if you’re married filing joint, and you could have zero dollar tax liability on that.
The way that breaks down is you would have up to $24,800 of ordinary income from whatever source (wages, labor, whatever) plus $80,000 of long term capital gains and/or qualified dividend income.
So the first bit, the $24,800 of ordinary income, gets standard deducted out, so it never becomes taxable income in the first place.
Then the $80,000 of investment income comes along, and it cannot get the standard deduction anymore because you’ve already used that.
But it will get the zero percent tax treatment in terms of the long term capital gains and qualified dividends tax bracket, provided that that $80,000 actually is long term capital gains and/or qualified dividends.
It has to be that character of income to get that zero percent tax rate.
I’ve mentioned this before, on a previous episode or two, that you can use this free tool online called TurboTax TaxCaster to actually test out your own numbers and run your own scenarios. You can punch in your own number assumptions and verify for yourself that what I’m describing here is correct.
I’ll put a link to that tool in the show notes which you can access at hackyourwealth.com/21. But I just wanted to explain the high level of how the six-figure income picture actually comes together for a married couple that allows you to result in zero percent or zero dollars in tax liability.
One thing I wanted to highlight is that the fact that the tax brackets for investment income are so much more favorable than the tax brackets for ordinary income is clear proof that the tax system favors people who own assets and collect rents and investment income over people who are actually working for their wages.
The proof is in the pudding.
The investment income tax rate doesn’t even begin to kick in until your taxable income exceeds $80,000, whereas your wage income gets taxed married filing joint once you exceed $24,800.
That imbalance is so large that that is a clear message the tax system is sending to you that it favors people who own assets and collect rents and returns on those assets over people who actually labor for their wages.
So knowing this, you can take advantage of this to do some tax planning.
If you’re a high earner, in normal years, you may not be able to take advantage of this, maybe because of your high income jobs. And that’s okay.
But whenever you have a low income dip, maybe your spouse takes time off work or you’re in between jobs or you take a sabbatical to travel, you’re out sick for a period of time or you go back to school, whatever it is, you can take advantage of this situation to optimize your finances.
You can manufacture, hopefully, some ordinary income that allows you to standard deduct it out. And then you can harvest some long term capital gains and qualified dividend income and get zero percent taxes on this.
The primary way to take advantage of this is to do a Roth conversion and harvesting of capital gains combination whenever your income drops for one of the reasons that I mentioned.
Again, maybe you take a sabbatical, you’re in between jobs, you become sick for a period of time, or you go back to school.
And specifically, what you can do is convert the amount of the standard deduction from a traditional IRA or a 401k over to a Roth account.
When you do that conversion, that money gets recognized as ordinary income. And if you convert an amount that’s exactly equal to the standard deduction, then that amount will get standard deducted out.
And then you can sell $80,000 worth of appreciated stock, recognize the long term capital gain, assuming you held that stock for at least one year, and pay zero dollars in capital gains taxes on it. Then you can immediately buy back that stock at a higher basis.
And this maneuver allows you to pay less taxes in the future when you eventually sell the stock for real because you have a higher basis at that point. And it also allows you to increase the chance that you can do some tax loss harvesting in the future if the stock dips lower later on, again because you have a higher basis.
Now, you could also skip the Roth conversion step for the standard deduction amount that I mentioned a moment ago. You could definitely simply harvest six figures of long term capital gains in appreciated stock, sell it all, pay your zero dollars in taxes, and then immediately buy it right back for a nice step up in basis.
But I definitely encourage you to do the Roth conversion because the Roth investment account has, by far, the best tax profile of any retirement account because all of its gains are tax-free forever.
Whereas just getting a tax-free step up in stock basis, like on a taxable account, which you can only do in a taxable account. You can’t do a tax-free step up in stock basis in an IRA or 401k or Roth account because those accounts have no notion of basis.
When you do a tax-free step up in stock basis in a taxable account, that’s just a one-time benefit. And any future gains above and beyond that will still be taxed.
So that’s why I urge that it’s a good idea to always have some money in a pre-tax, tax-deferred retirement account, like a 401k or an IRA, precisely to take advantage of opportunities like this where you can periodically march over some dollars from your pre-tax account to your Roth account.
And if you are contemplating early retirement, then after you FIRE, after you become “financially independent, retire early,” you can do this six-figure tax-free hack all day long, every single year you are early retired.
This is the central idea that I described in Episode 4 of this podcast where I described the Roth laddering technique. So I definitely encourage you to check out Episode 4 for all the details on that.
So to wrap it up, think about all the situations in your life when you might have low earned income.
That’s the key: low earned income.
And then do some planning around that to figure out how to manufacture high investment income to take advantage of these tax rules.
And this way, if you’re strategic about it, you can find some really nice opportunities to get a tax-free step up in stock basis, to move some dollars over from a pre-tax IRA or 401k to your Roth account, and to pay zero dollars in taxes and zero percent taxes on all of that.
It’s a nice free loophole that the tax laws give us to optimize our portfolio and to become more tax efficient.
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All right. That’s it for this week. Thanks for tuning in.
We’ll see you next time.
Check out the related posts I discussed here: