Understanding Capital Gains Tax Strategies | Cody Garrett | Ep 517

25:12Yeah. So they have permanently erased that tax liability on that game by actually selling it and realizing that's what's so wild about this. So really the takeaway here is if you are somewhere in this taxable income range that you need to very strongly a understand this concept that$94 ,050 is the taxable income threshold of the combination of this ordinary income minus all your standard deductions, et cetera, plus the long-term cap gains. If you're under that 9450 with the capital gains, all of those capital gains, the long-term capital gains are taxed at zero. So in Cody's example here, before capital gains came in, their ordinary taxable income was 70 ,800.

26:01Now keep in mind, the magic number is 9450. So when you subtract 94 ,050 and take away that's 70 ,800. There's 23 ,250 that the government is saying, this is$0 in tax you will pay on realized long-term cap gains. So you are literally throwing away a gift by not doing this, by just simply not knowing it. So you have to take advantage of this. You have to. It is critical. And it is your right to do this. And Cody, it's not hard either. That's the other beautiful part about it. Yeah. Two things that you mentioned that are really important. One is that the long-term capital gains are still included in your taxable income.

26:42The tax rate for long-term capital gains that are realized, those capital gains tax rates are based on taxable income. The actual realized gain is included in that number. If this person already had income of$123 ,000 of ordinary, the capital gains are stacked on top of that. It's funny. They're stacked on top of that from a tax perspective, but it's still included in the number. So to simplify that, I'll say it one more time. Your realized capital gains are still included in the taxable income number that you're using to measure which rate you're paying on those long-term capital gains. And the second part that's really important that Brad mentioned is this is federal income tax.

27:20So if you're living in California or New Jersey or another place that taxes their capital gains at the same rate as the state income tax or nary rates, you might actually get that free gift on the federal level, but still pay taxes on the state level. So determining whether that makes sense for you, depending on which state you're in. I'm in Texas where we pay taxes in a lot of other places, but not on income. Yeah. Like if I were in Texas or Florida or Tennessee or Washington state, like I would definitely take advantage of this opportunity. Yeah, this is really, really important stuff. So let's just finish this case study because I think while we've said the $20 ,000 of realized long-term capital gains are 0 % tax liability.

28:01They still have their tax liability on the ordinary income tax, right? Which we talked about, you said it'd be about $8 ,000, a little bit more, but this couple also has some child tax credits. So that'll reduce it further still. So talk us through just the end of this, and then maybe let's extend this case study to somebody making slightly less money. And we'll show how, again, there's this interesting interplay between the ordinary income plus the long-term capital gains and how much tax you pay. Yeah. So when you get on your 1040, if you want to break out your tax return from last year, just to have fun with us, effectively, you can see that at the bottom of that 1040, on the bottom of page one, says what your taxable income is.

28:44So if you're ever wondering, how do I determine my taxable income? You can actually look at an example, look at your tax return from 2023 or the year before, the last line on the first page says taxable income. So that's actually an IRS definition, not just a word we're throwing around. So look for taxable income. When you turn the page, that's the section, that first line on the next page is actually when you calculate what's called your tentative tax. This is kind of saying, okay, this is how much tax you owe before credits, right? And there are refundable credits in all various sources. But in this case study, there's a reason I added two kids under age 17, which means that they're going to receive a$2 ,000 tax credit for each child.

29:21So they're receiving a$4 ,000 tax credit. And Brad and I have talked in the past about the difference between deductions and credits. I think an easy way to think about this is a deduction is like the IRS giving you a coupon and a credit is like the IRS giving you a gift card, right? So if we kind of think about it this way, a deduction reduces the amount of income that's taxable and a credit is a reduction of the taxes you actually owe. So I just want to share in this example, we said, you know, their ordinary income, they paid about$8 ,000 in taxes on their ordinary W-2 wages of $100 ,000. They pay zero on the$20 ,000 long-term capital gain that were realized.

29:58So their tax, their tentative tax is$8 ,000, but they have a non-refundable tax credit of$4 ,000, which is 2 ,000 times each child under age 17, which means so 8 ,000 minus 4 ,000, their total tax, this family is$4 ,032 on total income of gross income of$120 ,000, which is a 3.4 effective tax rate. So they only pay 3.4 % tax rate on all of their income. And this is a family making$120 ,000. So this is not a strategy just for people in like the lowest or like below the poverty level. These are real deal families. A lot of people listening to this podcast. Yeah, that's why this is so important. And like I said a couple of minutes ago, please don't let this pass you by.

30:44At least at the very least, look at last year's tax return and just see roughly, like Cody said, what is your taxable income? You're going to have a sense. Obviously, if your taxable income is$300 ,000, you're not going to get the 0%. But if you're roughly in range, you need to really think about this. Because again, you're just passing up a free gift. You're passing up a free gift. And once it's gone, it's gone. You don't get to come. You need to do this this year. So you need to really strongly consider this. And Cody, just super quick, I'm going to put my CPAs hat on. I just again want to reiterate the deduction and the credit because you nailed it.

31:19But it's just so important. People use the term for deduction like, oh, it's a tax write-off as if it's free money and it's a, oh, I get to write it off. It does. No, no, no. Come on. If you're in the 12 percent tax bracket, which a lot of people frankly are, you're getting 12 cents on the dollar. So in some case, oh, I'm getting a tax write-off. It's free. You're spending some expense and you're only getting 12 cents back on the dollar. That makes no sense. So let's be clear. Most of us are in a dramatically lower tax bracket than we anticipate. And that's the value you're getting. So like Cody said, it's just this percentage, whereas a tax credit.

32:00Now that's where the money is. That is a dollar for dollar reduction in your tax liability. Like Cody said, this couple has roughly an$8 ,000 tax liability before credits, and they have a$4 ,000 credit. Well,$8 ,000 minus $4 ,000 equals$4 ,000. They just lopped off$4 ,000 in money that they otherwise would have had to have written a check to the federal government for. Let's be clear. A tax credit is dramatically more valuable than a tax deduction. I want to add, we've been talking about this as a gift that the government's giving us, right? The federal government is giving us a gift, like take advantage of that gift.

32:35I do want to share just a brief story about how tax gain harvesting can actually be used to help gift money to somebody else. Ooh, eyes closed on that one. That's impressive. There you go. Right. So Brad, you just mentioned this idea of like, hey, if you make$300 ,000, like you're not going to get 0 % favorable tax treatment, right? You're in the 15 % capital gains rate. But let's say you do make$300 ,000, but you have an adult child, right? And let's say that, for example, this is a real story. I literally helped somebody with this today. This is a single woman. She has an adult child with student loans.

33:09Again, a lot of us listening, we have student loans and maybe our parents, I don't know if you might have had a parent reach out and say, hey, like, is there anything I can do to help? Like, can we help you pay all these off? Like, if you're in that type of situation, there's an opportunity potentially for you, which is this person was in their highest earning years. they wanted to give money to their daughter. Their daughter is single with income of about $50 ,000. So kind of like those tax rates we looked at before, since she's single rather than marrying, filing jointly, kind of cut that number in half.

33:35So being single, her daughter, she has a 0 % long-term capital gains tax rate. If she can keep her adjusted gross income below or within$61 ,625. So her daughter has income of about$50 ,000 at work. So she has an additional $11 ,000 or so, she can fill up and pay 0 % on. So the parent, the thing is, the daughter doesn't own the stock, though. The daughter, you know, again, the only way to give this gift, at least from the parent's perspective was, hey, well, I want to help my daughter pay off her$30 ,000 student loan. And she actually asked me, hey, Cody, like, how can I get access to that$30 ,000 without having to pay 15 % capital gains since I'm in a nice earning year.

34:15And there's an awesome opportunity, again, the IRS set this up, that if you give a gift of appreciated, in this example, appreciated asset, appreciated security, it has what's called a carryover cost basis, which means that when you give a gift to somebody at a gain, it's effectively like that person you gave it to was the original purchaser of the stock. And then there's also a long-term holding period, which means even though when she gives it to her daughter, her daughter might just have it in her account for one day, she still gets to claim the same holding period as the person, as if she bought it when the person who gave it to her bought it.

34:47So in this example, she gave her daughter$30 ,000 worth of stock that had gains inside of it, let's say$5 ,000 worth of gain inside of it. Her daughter ended up selling the stock. So she realized a$5 ,000 capital gain, gained access to$30 ,000. And because the daughter was within the 0 % capital gains tax rate being single, she actually paid$0. She paid nothing in taxes to realize the gain rather than her mom taking on that gain. So if you're thinking to yourself, hey, if I have an adult child, and I want to transfer stock to them, I say there's two different ways that you don't want to give a gift in cash.

35:25One is charity. So same thing, rather than giving$30 ,000 to charity in cash, that same household I talked about, they can give$30 ,000 of appreciated stock directly to charity or to a donor advised fund. And again, they just eliminated that future realized gain from their life. And the other is if you're going to give a gift to a family member who's within the 0 % capital gains tax rate based on their income. So whether given to charity or a lower income family member or friend, again, you don't necessarily want to ask your family members, you know, how much money do you make? But most people are giving money to like their daughter or their son.

36:00And they'll say, Hey, could you just tell me kind of generally how much you make? And if they say, Hey, I'm single, I make about$40 ,000, then there's an opportunity there, whether you work by way, you don't have to work with a financial planner or advisor to do this stuff. And you can do it as a retail investor or do it yourself. But yeah, just anytime you're going to give a gift, just pause and say, first of all, never give a gift at a loss, sell, take the loss against your other gain and potentially up to 3000 of ordinary income, maybe another episode. But if you have something at a gain, say, can I give this directly to charity or give it to the person if they're at a lower tax rate than I am?

36:35Okay. There was a lot there. credit. That's incredibly valuable. Maybe another episode, yeah. No, no, no. That was fantastic. Just to summarize. So like you said, when a gift is given, let's forget the charity for a second. I'll come back to that. But when a gift is given, and this is any case, but in this case, we're talking from a parent to their child, they gifted this stock and it happened to be appreciated and it happened to be long-term. Now you said there's a carryover. So what happens is when the child received this stock, they receive it as if they purchased it at the price and the date that the parent purchased it.

37:12So that's for when they eventually go to sell it, which might be tomorrow or might be five years from now. And obviously we're talking in this case about tomorrow. And they're still selling at a gain. Exactly. But right. It's at that carryover. So in this case, the strategy is, okay, the parent would be subject to 15 % if they just wanted to give this in cash, They would sell the stock, they could hand the cash to their kid, but they'd have to pay 15 % on the long-term cap gains. Now they can just hand the stock, they can transfer the stock to their kid, the kid can sell it. And then because of the fact that they're in this 0 % long-term cap gains, it essentially eliminates that tax permanently because the child pays zero.

37:54So that is absolutely wonderful and just a really cool way to do this. just for anyone a little bit confused about the donating to charity, I think, Cody, that will be another episode. And I think we have talked about that in passing a little bit. But yeah, that's ever so slightly different in the sense that let's say you wanted to make a $1 ,000 donation to charity and you have long-term appreciated stock. There's almost no instance you can come up with where you want to just give the$1 ,000 in cash. You should donate the$1 ,000 in appreciated stock to the charity. The charity doesn't have to pay any tax.

38:28Let's be clear. That's a total non-issue. I actually had somebody question me in an email about that. I'm like, come on. Yeah, I'm giving this advice so that the charity is going to get stuck with it. No world, right? So the charity, that's a non-issue. And you have permanently eliminated the unrealized long-term capital gain by donating it. And you get the deduction at the fair market value, the current price of what you donated. Now, most people are not itemizing deductions, so they're not actually getting any tax benefit for charitable contributions. But nevertheless, if you were in a position where you were itemizing, you would get, in this case, $1 ,000 deduction.

39:07You would never pay tax on any of that long-term capital gains, and the charity doesn't pay tax. So this is a win all around. And on top of that, people say, well, I just gave my stock away, but I wanted to own that stock. What do I do now? They go, well, the$1 ,000 in cash you were going to give to charity, you can just buy more of that same stock with effectively a reset cost basis. Right. Because it's reset at today's higher or really the current, but higher than what you originally bought it. That's that permanent reduction in that unrealized capital gain because it doesn't exist anymore. You're buying it at today.

39:42So your new basis is today's purchase price. That's why this is so wonderful because it's a win for everybody. So Cody, that actually kind of got a little bit into the single person example that we were talking about earlier. And I think it's important, again, like we set up 20 minutes ago is really at the end of the day, these are very similar examples, regardless of your filing status. It's just the very specific standard deductions, different, the tax bracket's different, but it's easily something you can find via Google. That said, I know you're interested in talking about an example of a single person who just retired early.

40:17So let's use that as kind of the landing place for the single example. Yeah. So in this case study, let's take a single taxpayer. Let's call her Ann. She's age 50. She retired last year. She has no form of income this year. So one really important thing about, you know, before we talk about the tax opportunities, we have to talk about what is it like in early retirement? And one of Ann's biggest fears is healthcare. Like a lot of us are worried about our health coverage in early retirement and also the cost of that. So Ann has decided she's not working and she's not taking advantage of COBRA from her prior employer's health insurance plan.

40:52So she enrolls in the health insurance marketplace. Some people call it ACA, some people call it Obamacare, the exchange, lots of words for it. But healthcare.gov is where you go find more information. But she needs coverage through the health insurance marketplace. And what's great about Anne is that she knew she was going to retire early. So she went ahead and set up, let's say she lives off of$50 ,000 a year in early retirement. She actually has$50 ,000 set aside in cash. It's liquid. It's stable. She already has her money ready for her for her first year of retirement. But at the same time, she's worried.

41:22She wants to make sure that she doesn't have to pay a boatload of money for her health insurance early retirement. So she goes to the health insurance marketplace. I actually have a video. Again, maybe we can link to the video on how to shop around on the website. But she actually finds out by being a single taxpayer, age 50 in her area, to receive any premium tax credit for health insurance through the marketplace, her income, her modified adjusted gross income, which is practically her adjusted gross income needs to be at least$20 ,000 to even receive a tax credit. So what's funny about tax credits, at least in terms of health insurance called the premium tax credit, is that it has a floor and effectively a ceiling, which is a lot of people say, hey, well, if I don't make any money, I'll get free healthcare.

42:04But there's a difference between getting free healthcare through Medicaid and free healthcare through the marketplace. So most people going into retirement, again, And just the most people I talk to, they want a similar plan like they had before they retired. They want like an HMO or a PPO plan where they can go to different doctors in different areas within the network. So one common example is let's say Ann finds a Blue Cross Blue Shield plan in this example that cost$6 ,500 per year if she didn't get any credits, right? So she'd pay about 540 bucks a month. But she notices on the healthcare.gov website that if she can bring up her income, intentionally bring up her income from some source somewhere to$20 ,000, her entire plan will be free.

42:45All of her health coverage will be completely subsidized. So I shared an example where Ann goes on the marketplace. She chooses her high deductible health plan,$6 ,500 a year. Again, the next example, Blue Cross Blue Shield. But she actually needs income to receive the credit. So she's like, where do I take my income from? And again, maybe she has a few options. She can say, I have a traditional IRA that I rolled over my 401k for a traditional IRA, and I have an opportunity to do this tax gain harvesting. So she has an opportunity like, which one should I choose? Should I do some Roth conversions, right?

43:17And fill up those lower tax brackets, or should I do tax gain harvesting to fill up that 0 % capital gains tax rate? Again, a lot of the feedback to me is like, which one should I prioritize? Earlier, we talked about the standard deduction, right? So the standard deduction for a single filer is$14 ,600 under age 65 in 2024. Got to get the numbers right. But you can see effectively the government saying, hey, your first$14 ,600 of income is tax free. So I'll ask you, Brad, if somebody was giving you$14 ,600 in free income, would you rather that income be ordinary or long term capital gains? I mean, standard terms, ordinary.

43:54Absolutely, right? So the ordinary is taxed at a higher rate typically. So you want to go ahead and take advantage of that, what they're giving you, the standard deduction, it's kind of like a 0 % ordinary tax rate for you. Right, at your top marginal rate. Exactly, so Anne is super strategic. She listens to the Choose the Fight podcast. So what she does is she converts$14 ,600 from her traditional IRA to her Roth IRA. And she's like, wow, I just did a free Roth conversion. I got a deduction upfront when I contributed to that traditional retirement account, and now I'm paying zero tax at the federal level.

44:24But she has some additional gross income she can fill up with the long-term capital gains. So she decides to realize pretty much up to the cap, she realizes$47 ,000 of long-term capital gain. So the$47 ,000 plus the$14 ,600 from the conversion, it makes her gross income$61 ,600. She removes back out the standard deduction, which is the same amount as her Roth conversion. So now her taxable income is the$47 ,000 that was long-term capital gains. Since she's in the 0 % capital gains tax bracket, all 47 ,000 of the long-term capital gains are taxed at 0%. And as we just mentioned, her Roth conversion was completely unwound by the standard deduction.

45:05So it's amazing that her adjusted gross income of 61 ,600 is all taxed at zero on the federal level. And on top of that, her income is now high enough that she's going to get a premium tax credit. In the example I have here, so by having income of around 60 ,000 modified adjusted gross income for health insurance purposes, she's going to receive$3 ,000 a year in the premium tax credit. So her health plan costs$6 ,500. And now it's going to cost $3 ,500 because the IRS just gave her an advanced premium tax credit of$3 ,000 because she kept her income within the range. Interesting. Okay. That was pretty roundabout, but we made it there.

45:47No, that's it's important. Right. So there is a significant interplay. And interestingly, like you said, you don't want taxable income too low, because then if you're under a certain threshold, and I suspect it's state by state. But if you're under a threshold, then you might be on Medicaid as opposed to getting a normal health insurance plan that's that you get through the ACA, but you get these subsidies. So interestingly, and Cody, I wouldn't have even known this necessarily, was that these long-term capital gains count towards that income for the thresholds for the premium tax credits. I think I would have realized that at the end of the day, but in terms of that floor, I think most people think, oh, this is just my income, my regular income.

46:35But it's not that. It's these sources of technical income on the tax return, and that's the important part. And one little add here, in this example with Ann, she actually needed income to get to the floor of$20 ,000. She decided to do more. But keep in mind, it's really important to know that even if long-term capital gains that are realized are taxed at 0%, it's still included in your adjusted gross income for purposes of the premium tax credit for health insurance. And the numbers I ran earlier, even though she's paying 0 % taxes on her long-term capital gains, the reduction, ironically, again, she needed income of at least$20 ,000 to get health insurance subsidies.

47:16By having income higher than that, even though Anne paid 0 % taxes on her long-term capital gains, now on the flip side, the reduction of her premium tax credit was actually kind of, it's not really a tax, but the reduction of her credit actually is like she was taxed effectively 8.5 % on her long-term capital gains. In her mind, she paid 0 % tax on it. But by actually going over the minimum, she actually reduced her premium tax credit by adding taxable income. So it's this really fine balance. I have a video that I'll share in the show notes that effectively shows you how to look at if I realize 10 ,000 more, 20 ,000 more, 30 ,000 more, how will that affect my premium tax credit?

47:57So this is a very common example. Most people in early retirement, They're going to take advantage of the health insurance marketplace. So just make sure that you understand that all forms of income, modified adjusted gross income, are used in the calculation for how much health insurance subsidy you receive. So Cody, that was great. That was really thorough. As we kind of end out the episode here, so we've done our case studies. Is there anything just real quick that people should consider? I know we've touched on a lot of different topics, but just anything else that you didn't touch on that you just wanted to mention in passing?

48:29Yeah, I think the most important thing here is to do things in the right order. So in terms of kind of figuring out what to buy, what to sell and investments, I say that the most important part is your ability to maintain your desired lifestyle, especially if we're talking about early retirement here. So you probably heard the phrase, don't let the tax tail wag the dog. I just want to make sure don't look at capital gain harvesting as a strategy to prioritize. It's kind of like tax gain harvesting is really in that top 5 % to 10 % of optimizing your financial plan, but it shouldn't lead your financial plan.

49:02So in the example I share with Anne, again, we want to make sure that Anne maintains her desired lifestyle. Like if she wants to go on a Viking cruise with her friends, spend a ton of money on awesome vacations during the go-go years of retirement, like, you know, assuming that she can afford it in terms of her total financial landscape, yeah, prioritize living your best life. With that said, the implementation of how that happens, that's when you start looking at these opportunities. Like, hey, do I do the Roth conversions? Or do I do tax gain harvesting? Or do I do tax loss harvesting, which is kind of on the flip side of, do I try to take advantage of some lots of investments that I can sell at a loss and use up to$3 ,000 against ordinary income?

49:41There's a lot of strategies here, but just know these are optimization strategies. You don't go into retirement being like, I'm going to do whatever it takes to take advantage of the 0 % long-term capital gains tax rate. The most important part is that you prioritize your ability to maintain your desired lifestyle. and only in the implementation do you start bringing up your spreadsheets and all these websites and videos and more advanced strategies. I do think it's usually worth the hassle. We call it the ROH, the return on hassle is large on some of these opportunities, especially for tax credits, since it's that reduction of taxes owed.

50:15But just keep in mind, always start with, hey, how much money do I need to maintain my lifestyle? Figure out what sources are helping me gain access to that income. If you need to sell investments to gain access to that income, you'll sell those investments. If you need to take money out of pre-tax retirement accounts or use SEPP or some of those early retirement strategies, do that. Do whatever it takes to get your money that you need to live. And then only after that, only after you maintain your desired lifestyle, look at those additional opportunities and strategies that we're talking about today.

50:45That is great advice. Absolutely great advice. Cody, thank you so much for being here. So as I mentioned at the outset, Measure Twice Money is your informational site where everybody can go and just get a wealth of resources. What's wonderful about you, I know you said repeatedly you are a CFP, but you're not looking for clients. So there's no conflict here at all. You're just a wealth of information and help to our community. And I really appreciate it. I love doing these deep dives with you. Absolutely. I'm so glad that you invited me back to try to give back more than I was given from you. Well, I appreciate it, my friend.

51:19And yeah, for everybody out there, if you're looking for more of these deep dives, send us topics in. Feedback at chooseofi.com. Let us know what you want us to talk about next. And we'll, as you can see, Cody comes up with just these amazing case studies and really interesting examples. So we find a way to hopefully make it interesting, even though it's a little difficult to do math on a podcast. But I think we did our best here, Cody. So until next time, thanks for listening to Choose a Vi and for being part of our community. Thank you for listening to today's show and for being part of the Chooseify community.

51:52If you haven't already, the best ways to get involved are first subscribe to the podcast. So you're listening to this on a podcast player and just hit subscribe and then subscribe to my weekly newsletter. I actually sit down every Monday and write this by hand and I send it out Tuesday morning. So just head over to chooseify.com slash subscribe. And it's really, really easy to get on the newsletter list right there. and I would greatly appreciate it. It's the best way to get in touch with me. You can actually just hit reply to any of those emails and it comes directly to my inbox. So that's the way that I keep a pulse of the community and how we keep this the ultimate crowdsourced personal finance show.

52:31And finally, if you're looking to join an in real life community, we have Chooseify local groups in 300 plus cities all around the world. So head to chooseify.com slash local and you'll find a list of all of those cities in 20 plus countries all across the world. And if you're just getting started with FI or you have a family member or a friend who you think would be interested, two easy ways. Choose a FI episode 100 is kind of our welcome to the FI community. And even though it's a couple of years old at this point, it still stands up and it's a really great just starting point to get an understanding of what is financial independence?

53:07What are we doing here? Why are we looking to live a more intentional life where we save money and use it as a springboard to live a better life. And then Choose a Vi created a Financial Independence 101 course that's entirely free. Just head to choosefi.com slash fi101. And again, thanks for listening.