Business ownership is one of the best proven ways to gain wealth. To get super-rich, you need to actually own or start a business and be successful in profitably growing that business. Personally that seems risky to me and way too much work.
So I do the next best thing; I buy ownership shares in businesses through the stock market. Risk is minimized by owning low-cost, diversified index funds across many industries, companies, and countries and holding that ownership over long periods of time.
A lot of debate goes into pros and cons of different investments, mostly based on risk versus expected returns. But a key factor that gets less attention, probably because the details can be complicated, is how to convert those investments into spending money. And a key part of that is taxes.
The tax advantages of real estate is something people are generally familiar with, since so many are familiar with the mortgage interest deduction on their own primary home. They also realize that investment real estate like rental properties also has tax advantages from the use of leveraged money (i.e. loan interest deductions) plus depreciation and deductions for expenses related to maintaining the property. Then there is the fact that significant profits can be taken on the sale of a property without incurring any tax burden on those profits. All of these tax benefits are a key reason that real estate investing is so popular and financially lucrative. Without the tax code supporting real estate so much, it would be a much less attractive investment.
But real estate also requires quite a bit of work. Even if you pay a management company to do all the day-to-day things, it still takes a lot of active effort to find investments, work deals, manage the management company, etc. That’s way too much like a real job to many people, including myself.
This is why I prefer more passive investing through stock funds, or real estate through REIT funds. You may give up some returns compared to a good, active real estate investor, but you’ll still likely get attractive long-term returns and have lots of time to do something other than manage your assets. Plus, there is more risk as an active investor since skill is critical and many of of don’t have it.
Something that is not covered as much with regard to stock investing though, is taxes. Everyone knows that capital gains tax rates are lower than tax rates on wage income. But seldom does it go much further than that. But there are some really nice advantages to the way the tax code is set up for investors and it’s worth covering a few topics.
Taxes on investment income are lower than wage income
This is a well-known fact. Governments do this to encourage investment which is critical to long-term economic growth. In the news, it’s often brought up as an issue in debates on income inequality and there are certainly arguments to be made on that front. Hedge funds in particular are pretty clever about turning regular profits (which normally would be taxed as wage income) into a type of capital gains so that their income is taxed at a lower rate.
I won’t get into a philosophical or political debate on this. I’m a pragmatist who tries to understand the “system” as it exists and take actions based on this understanding.
Regardless, for regular passive investors who are not actively making money through their direct efforts but instead have their savings invested so they are partial owners in businesses, (and get some share of the profits that are generated) it’s generally seen as okay that investment tax rates are lower than wage tax rates. After all, their money was originally taxed when it was earned as wages and now dividends plus capital gains earned on that money is going to be taxed again.
It also seems reasonable to expect that tax rates on “capital” will continue to be lower than tax rates on income to encourage capital investment and long-term economic growth.
Where this all stands currently in the US, is that if you are in the lower tax bracket (15% or lower), your capital gains tax rate is actually zero! This means that if you are married and filing jointly, you can earn around $75,000 (actually a bit more since there are some normal deductions to get to your adjusted-gross income (AGI) used in tax calculations) before any capital gains are taxed at all. This provides several powerful options for how to convert your savings/investments into spending money.
Note that your capital gains are factored in to determine your AGI even though they are taxed differently. So in order to actually pay zero taxes on your capital gains, you need the following equation.
Total AGI < the top of the 15% bracket ($75,900 for married filing jointly in 2017).
AGI = wage, pension, interest, etc and capital gains income – deductions (standard or itemized). This AGI number determines if you are still in the 15% bracket and will pay 0% on your capital gains.
Deductions for a family of four would be about $20,000 so you could make around $95,000 in income including capital gains and pay zero tax on those capital gains (dividends are treated in the same tax-advantaged way).
Even if you go above this a bit, it’s okay because you still pay zero taxes on the amount up to this. For example, let’s say you have $50,000 in capital gains and it makes your final AGI $80,000, pushing you above the 15% bracket and into the bracket where your capital gains are taxed at 15% instead of 0%. In this case (using the married family of four example), only $4100 ($80,000-$75,900) is taxed at 15%, for a bill of $615. The other $45,900 of your gain is still not taxed at all.
Final note: There is a minimal holding period (1 year for stocks, less for dividends) for investment sales to be treated this way. If you sell before this, it’s considered a short-term gain and is treated and taxed just like regular wage income.
So while it can get a bit complicated managing income streams and figuring out how to optimize around taxes, there is clearly a big tax advantage of investment gains, particularly at lower income levels.
A somewhat lesser-know tax element of investments is tax-loss harvesting, although this is getting more known now that robo-advisors are using algorithms to try to get a bit of extra return using tax-loss harvesting. In a nutshell, if you make a stock investment and it declines in value, you can sell that investment as a loss and that loss can be deducted from your taxable income (up to $3,000/year, with the excess carried into future years) or any gains you have in other investments.
This can be a really nice benefit, especially if you have a high income that places you in a high tax bracket. Unfortunately, there are two big limitations.
- This is more useful for “new” money. When you first invest money into stocks, they could go up or down (often a lot) in a nearly random fashion, so you easily end up with some losses to use (remember that short-term timing impossible or at least very close to it). However, over time, it’s extremely likely that the value of your investments will increase and continue doing so, despite the future ups and downs in the market. It’s not very common for very long-term investments (10+ years) to fall below the price you paid for them. Capital “losses” are only counted if it’s a loss vs what you originally paid, not a loss vs some peak value that your investments achieved. So the chance of a capital loss decreases over time. This “new” money factor is why robo-advisors, in their current rapid growth phase, or active traders, can use this method across their portfolio to provide a small extra gain. They are often making new investments and short-term these investments often decline in value.
- This is mainly useful for those in a high income tax bracket where the tax deduction has the most value.
These issues lead to a third factor that is essentially the opposite of tax-loss harvesting and is understood to a much less degree.
This is the least discussed factor of the three but it is very powerful for many of those in the FIRE community who are asset-rich but tend to have low taxable incomes. In cases like these, tax-loss harvesting is the opposite of what you want to do. Instead of selling investments that have declined in value, you want to sell your investments that have increased in value.
If you sell a stock that has gone up in value, then you trigger capital gains. But capital gains are taxed at much lower rates than ordinary income. This is one reason I prefer stocks vs investments that generate ongoing returns that are taxed as ordinary income. Income-based investments can push your taxable income too high and put you in a higher bracket.
Instead, you can have a large stock portfolio and have a very low taxable income because you get your spending money from capital gains on the stocks you sell and these are taxed at a much lower rate. As mentioned before, currently the tax rate on capital gains is 0% for those with a household income of around $85,000. This is a pretty high income that provides a nice standard of living. And if you want more money and have really large portfolio, you pay a low 15% tax until you hit nearly a half a million on annual income as long as it’s coming from capital gains! If you get this income from wages, then you’re paying between 25% and 35% on this income.
This preferential tax treatment makes stock investments a pretty appealing income vehicle for retirees.
Even when you don’t need the money for spending, when your taxable income is low enough to qualify for the 0% tax rate, it’s a great idea to routinely sell your stocks that have appreciated in value. You sell your stock, triggering a capital gains based on the current price vs what you paid in the past, but don’t owe any tax on that capital gain. Then wait 30 days (to avoid the IRS wash sale rules), and buy it back at the current price.
This is called increasing your basis and it’s the opposite of tax-loss harvesting.
This way future capital gains are lowered since they will be based off the new higher starting price of your investment. This can really help in future years if you end up in a higher tax bracket due to more taxable income, such as a pension, a future job, or higher interest income from more conservative investments like bonds as you get older. Even social security can add to your taxable income. It’s also a hedge against the potential for higher capital gains tax rates in the future (after all, our growing national debt will require action at some point).
Final Tips on How to Use this Knowledge
When you’re working and in a higher tax bracket, tax-loss harvesting is a great tool. Continue to use this whenever you can. When you retire and have a lower “taxable” income, then capital-gains harvesting becomes your friend.
So the best strategy is determined by your tax bracket (i.e. taxable income).
When you are working and in a higher tax bracket, it’s much better to not sell any of your investments that have appreciated in value. You will pay a much higher tax on any gains (although lower than on your job income). For high income earners, you’ll also currently face the additional 3.8% tax on investment income for a total upper tax rate of 23.8%.
If you can wait until your income drops after retirement to sell those same investments, then your tax rate drops to zero on the same gains. So ideally when you make an investment during your working years, plan to hold it until retirement unless there is a very strong reason to sell. Once your taxable income is lower, you are free to take any gains you have and you get to keep all of them, instead of sending a quarter of those gains to the government.
Just stay below the thresholds I mentioned before and you’ll pay 0% on your gains. If you have a lot of capital gains, you can sell some each year (staying below the 15% bracket limits) and after a few years, you’ll have converted a lot of gains that would have been taxed at 15% into gains that are taxed at 0%. And you’ve reset your basis higher so that your future gains will be taxed less as well!
One final note as a disclaimer: I am a scientist by training, not a financial planner or tax professional. I am also currently still working and haven’t been able to put this into practice myself yet so before you follow this path, please check with a tax professional before doing so. The rules are pretty clear but I’d still be nervous about selling an investment with a large capital gain without double-checking what tax you will owe on those gains with an actual tax professional.
Any comments from those that use this approach? Or is there a different method that you use to improve your investment returns based on tax policy? I’d love you hear about your experience or thoughts.