What’s That Tax Rate?

Steven Jarvis:     Well, hello everyone and welcome back to The Retirement Tax Podcast. I am one of your co-hosts, Steven Jarvis, CPA, and of course I have with me the legendary Benjamin Brandt. Ben, how are you?

Benjamin Brandt:         Happy to be here. First time, long time.

Steven Jarvis:     First time, long time. I think this might not be the first time, but glad to have you back as always. Today, we’re going to talk about a couple of different things. We got a really good listener question that I know a lot of people have, so I’m excited to get to that, but before we dive into that, we want to talk a little bit about capital gains tax rates.

                           It’s a question that’s come up a couple of times recently as I’ve interacted tax payers, and so anytime I start hearing a question multiple times, I figure that more than just those people have that question. So, I thought we’d chat a little bit today about what … we’ll use the example that came up most recent with the taxpayer of, “Okay, what happens when I finally get around to selling some stock that I bought years ago, because I was excited about a company? This is my first time selling stock. What does that mean for tax purposes?”

                           We get lots of opportunities to learn new things when it comes to taxes. For this taxpayer unfortunately, they had gone ahead and done this before they were working with an advisor or a tax planner. It was early in the year that they had sold a pretty significant amount of stock, because they’re really excited about it. Which great, I was excited for them too when they told me about it.

                           But what they didn’t realize is that not only would they have to pay tax on the gain, but that the IRS expects you to pay tax when your income is earned. Which means that not only do they have to write a check for the taxes at the end of the year, they had to write a check for a penalty, because they didn’t pay the tax at the time the income was generated.

Benjamin Brandt:         Yeah, that’s tricky. That’ll happen. We think of taxes, taxes are due April 15th, but yeah, in reality, if you sold that stock January 15th, the meter’s running.

Steven Jarvis:     Yeah, the IRS likes to have their money when you have it, and so when we earn the money is usually when they expect it from us.

Benjamin Brandt:         My kids have that same idea.

Steven Jarvis:     My kids just want the money all the time. The other thing to add some confusion here is that we have different income tax rates for long-term capital gains. It’s an important distinction, it’s not all capital gains. So when we sell stock, when we sell a piece of property, potentially when we sell a business, there’s these different income events where we potentially get a preferential tax rate. They are better rates, so when we can, we want to make sure we’re taking advantage of those capital gains rates.

                           But the IRS doesn’t make things easy for us, and so I hear confusion all the time as to how these rates work. I think where a lot of the confusion comes from is this optimism that we’re going to fit all of our capital gains income into the 0% bracket. Which, I’m right there with you. I’ll take as much income as I can at 0%, but the IRS unfortunately isn’t very generous. The most common misconception I hear from taxpayers is this idea that whatever bracket I start in when I have capital gains is the rate I get for all of my capital gains. So, let me give an example of how this works.

                           We have two different kind of buckets of tax brackets. We have our ordinary income and then we have our long-term capital gains income. So what’ll happen is that for a married couple filing jointly for 2022, the first $83,000 roughly of capital gains income is taxed at 0%, if that’s the only kind of income we have. This is where it gets tricky, is that the IRS is going to stack our different types of income together, and they’re going to start with our ordinary income.

                           Which at the end of the day is better for us, because those rates are higher, and so they start with ordinary income, we fill up those brackets and then we have to add the capital gains on top of that. Just like on the ordinary income side, our income is going to push us through multiple brackets potentially.

                           So if we take this married couple filing jointly, and we know that up to $83,350 is potentially in that 0% bracket, what really happens is if they have $80,000 of wages of earned income and then another let’s say $50,000 of capital gains, really we use up most of that 0% bracket with our ordinary income, which is going to get taxed at the 10% and 12% rates, and now we’ve got to add our capital gains on top of that. So we actually only have a couple thousand dollars in that 0%, and then the rest of it goes into the 15% bracket.

                           I know that on a podcast without a visuals or a whiteboard, it can be hard to follow the numbers a little bit, but really this is just to illustrate that while it would be nice to say, Hey, I’ve only got $80,000 of ordinary income, so great, I’m in the 0% bracket, let’s go sell all of my stock.” That’s not how it works, it’s going to keep moving through those brackets.

Benjamin Brandt:         It’d be nice if it worked that way, but I think the IRS saw that one coming and decided we’re going to stack these things together and get some revenue.

Steven Jarvis:     Yeah, the IRS does like their revenue. By the IRS, we mean Congress, but yes, they’re going to get their revenue. So if it sounds too good to be true when it comes to taxes, that’s probably a good time to seek out a professional and ask, because it’s probably not as good as you think it is.

Benjamin Brandt:         Right. It’s possibly available to you, but there’s very specific things that you’ve got to do. It would be very difficult to do during your working years. I mean, I suppose you could call your boss up and say, “Don’t pay me next year, because I want to sell some Google stock, because they’re doing a split.” But in reality when you’re retired, you’ve got much more latitude and longitude to decide what you want your income to be.

                           So in theory, if you’ve got a big severance package or something or a buyout and you get all of your income in one year and you’re not going to have any income for a year or two, what an amazing opportunity then to start to ladder out some capital gains out of your brokerage account or whatever it would be to intentionally create a 0% income year, $0 income year and then strategically fill those bottom brackets up with gains, and that’s paid no income tax on some of your capital gains.

                           So obviously that doesn’t happen overnight, you’ve got to have lots and lots of planning. Either a super sleuth DIY investor that listens to this show or somebody that has a very talented financial advisor, but either way it’s possible, but not without lots and lots of planning.

Steven Jarvis:     Yeah, on our last episode, the listener question really pointed us towards this long-term planning idea. We were talking about Roth conversions and minimizing taxes out of a 401(k) in that case, but if we have the potential for capital gains, really we got to start in the same place of if we’re looking to sand off the rough edges of the taxes we owe, we’ve got to take a multi-year approach and look ahead to say are there decisions we can make about when we recognize the capital gain income and what other income there might be that year to see how we can maximize these lower bracket year?

                           Something else I always like to remind taxpayers of when it comes to capital gains is that, again, the IRS wants their money when you have it. There’s only so much generosity in the rules, especially when it comes to recognizing capital losses, because just like we expect investments to go up at times, inevitably there will be times where we’ve picked some that maybe didn’t work out as well.

                           While the IRS will tax you on every last dollar of your gain in a year, they limit how much of your loss you can use to offset income in a given year. So we can use our capital losses to offset other capital gains within the year, but if we have a year where we only have capital losses or our losses are larger than our gains, the IRS says, “Nope, you can’t just keep offsetting other types of incomes, we’re going to cap it at a $3,000 loss that you can recognize in a single year.”

                           So let’s say we had a really bad year, we had $20,000 in capital losses. IRS is going to say, “Nope, you only get $3,000 of that this year to offset your social security income or your dividends or wages,” or whatever it might be, what other types of income you have. We don’t to get offset the rest of that. We’re limited at $3,000, but the other $17,000 we can carry over to a future year. Either if we never have gains or losses again, we’re just going to keep recognizing $3,000 of that each year until we run out, but we can use it in future years when we do have gains to offset those losses.

                           But this is important to keep in mind, because that’s something we have to keep track of and we have to make sure that we’re taking advantage of. The IRS is not going to remind you, they’re not keeping track for you. We get to the next year and you have $17,000 of gains and you forget that you had a carryover loss, the IRS is not kind enough to call you and say, “You know what, Ben? You actually have these losses, so we’re not going to charge you any income tax, because they all offset.” At least in my experience that phone call hasn’t happened yet.

Benjamin Brandt:         I wouldn’t hold my breath.

Steven Jarvis:     Yeah. Yeah, especially with the backlog the IRS has these days. A lot of times tax prep software will help with this, but it’s definitely something we want to keep track of and make sure we don’t miss out on, because, I mean, it’s bad enough we have the loss we need to recognize, we don’t want to also miss the tax benefit.

Benjamin Brandt:         Right. So if we have a loss, we can match long-term losses against long-term gains, short-term losses against short-term gains, and then whatever is remaining is income. So in the unfortunate circumstance that we do have losses, are we able to use those to our benefit? Do we have to match long-term gains and long-term losses, and short-term losses and short-term gains, and then income after that, $3,000 a year till we run out? If we have a big loss that we are realizing, are we able to match that up with a gain in our portfolio somewhere else and take advantage of it if we don’t see a big benefit of the $3,000 kind of carryover?

Steven Jarvis:     Definitely. Yeah, that’s a great point. We can be really strategic about this and not just wait until we happen to have a gain, but this can become part of our planning toolkit, because one of the nice things the IRS allows us to do is what we call capital gain harvesting. Which you can sell a stock at a gain that … and maybe in a stock you’re really excited about, you can recognize the gain, pay the taxes and immediately invest in that same stock, and so you essentially are resetting your basis higher.

                           This is one potential planning strategy for if you have losses that you’re trying to use up. This is in contrast to when we sell stocks at a loss, because when we sell a stock at a loss, the IRS has what they call their wash sale rules and there’s limitations on buying back that same stock.

Benjamin Brandt:         Oh, interesting. So yeah, so it would be the opposite approach. If you think your income is going to go up next year and the market has been on an incredible bull run and you’ve got lots of deferred gains, you could harvest the gains during a lower income year, get your larger income next year and then remove the risk of maybe needing to rebalance or balance out some risks or things like that, redistribute. Yeah. Yeah, I think many people have heard of tax-loss harvesting, but tax gain harvesting also has a place, so that’s very interesting.

Steven Jarvis:     Yeah, I’m a big fan of capital gains harvesting as well, because it resets that basis. It has kind of a similar element in my mind to doing Roth conversions, in that we’re intentionally paying taxes now to remove the IRS’s ability to change the game on us later.

Benjamin Brandt:         Right. Especially if there’s always the looming threat of pending legislation and things like that. Carrying huge amounts of gain is great to defer those taxes, but we never know when that tax bill might be due. There’s always the option that we could die with it. Actually there isn’t, because that is also a looming legislation that might go away, so we’ll scratch that. But it always used to be, yeah, either pay the taxes or planning on dying with it and then you get to step up in basis. But, well, stay tuned, if that’s going to be a rule this time next year. Who knows?

Steven Jarvis:     Yeah, the other reminder I always like to throw out is, going back to our example of the taxpayer who was surprised by this tax bill, make sure you look at the state rules as well, just because they might not align with the federal rules, as far as the rates or when the tax is due.

                           Obviously we’ve got a handful of states that don’t have income tax, that list is getting smaller. In Washington State, actually one of the states that’s notorious for not having income tax, they’ve recently implemented a capital gains tax. So, you want to make sure that you’re also checking the state rules that you don’t get caught off-guard by the state at the end of the year either.

Benjamin Brandt:         Excellent. So we’ve got a listener question for you, Steven. Anonymous listener writes in, “Question on the five year clock for Roth conversions. I’m doing conversions from an IRA to a Roth IRA. Currently I’m 58 and I’ve been doing them since 55. When I get to 59 and a half, what can I withdraw without being penalized? Conversion amount, growth, dividends, and capital gain distributions?” What say you, Steven?

Steven Jarvis:     Yeah, this is a great question, a really common question. It comes up a lot, because there’s actually two different five year rules when it comes to Roth. One is on Roth contributions and the other is on Roth conversions. There’s a really key difference between the two, because the clock on the contribution starts with the first time we make a contribution and then does not reset as we keep making additional contributions.

                           This is in contrast to the conversion clock, which is what the listener is asking about, and the five year clock on conversions is on each conversion. So, that’s a really important distinction. So that five year clock is there, it does exist, we want to make sure we’re aware of that, but really, Ben, I’d love to get your input on this, because rather than dive through all of the nuance of the rules on the five years, really we want to talk about from a planning perspective, what makes the most sense as far as how we use those Roth dollars? Because quite often it really isn’t even going to be an issue, because that’s not the first dollars we’re going to take out.

Benjamin Brandt:         Right. Yeah, so when this came up as a question and as a topic, I had to go back and do some research, because the five year rule, how we use Roth IRAs, doesn’t come up all that often, and I’ll tell you why. When we think about the benefit of the Roth IRA, it’s that we’ve already paid income tax on it, and the growth is what’s really valuable. Our beneficiaries, should we be in a position where you don’t spend all of it? I hope you do spend all of it, but if you don’t, your kids or whoever you leave the money to, your nieces and nephews or grandkids, whoever it is, they’re not going to pay taxes on it, because we already pay taxes as the rules stand now.

                           Also, the growth is what’s beneficial. Just from the basics of investing, the longer of a timeline we have, the more growth that we could expect. The longer we’re in the market, the better returns. So when we kind of match those ideas up, I want my Roth to be the last dollar that I spend. So when I do a contribution or a conversion, I want to put that in the bucket that’s going to grow the fastest and grow the most, and that’s going to be the bucket that is the longest away from my spending today.

                           So I’m going to spend out of my IRA, possibly probably first, and then if I have a joint account or a brokerage account, I’m going to supplement my spending with that, or maybe lump sum spending. I’m going to do tax-loss harvesting, I’m going to do those sort of things, but then my Roth is going to be the last thing that I look to for income, because of growth, because of beneficiary options. Because of if there’s big health insurance or health costs or nursing home costs, I want that to be my supersized emergency fund contingency plan to have this huge piece, this huge bucket of tax free portfolio that I could take income or lump sums from in the future.

                           So I know that there’s going to be a forcing point with my IRA at 72 where I have to spend it, so that’s my focus now, because I don’t want to spike the football of income and income taxes now, so I’m saving that Roth until later. So while it’s important to know the five year rule and some of these things, how I do planning for clients and how I do it for myself is that it’s not going to come up, because that’s the last money that we’re going to spend.

                           So important to know the rules, but if your plan works in a way that the rules don’t matter, then that’s great too. But especially for emergencies and things like that, we want to know what are the consequences taxes and otherwise of taking money out. So important to know the rules, but there’s a good chance it might not come up.

Steven Jarvis:     Yeah, love that description. That’s a great way to approach it. If you’re listening thinking, “I missed my shot to plan it that way, or hey, I mean, I really need to know exactly in my situation how the rule applies,” totally understand. This is a great time to take a step back and think is it time for me to engage with a financial professional, a tax professional? Or if you’re a real committed DIY, at the very least call the custodian or whoever administers the account to say, “Here’s what I’m thinking about doing. What’s this going to mean in my situation?” It’s certainly not something you want to guess at and then try to sort out come tax time.

Benjamin Brandt:         I agree wholeheartedly.

Steven Jarvis:     Well, Ben, it’s been a pleasure as always. Thanks for sharing your perspective. For everyone listening, until next time, remember to not let the tax man hit you where the good Lord split you.