Good news for you and your projection sheet. If you’ve been baking in income taxes in your retirement plan, you may actually be closer to retirement than you think.
For most of our working lives, we generate a sizable amount of income. That bumps us into higher tax brackets for our long term capital gains. But the government wants to encourage those with little income to invest, and it has decreed that for a wide range of incomes that it will actually not tax any long term capital gains at all. When you retire, you become part of this special group.
Let’s see how it works.
Federal Tax Brackets
Here is a chart of current federal income tax brackets.
One thing that jumps out in this chart is how advantageous it is to qualify for long term vs short term capital gains. To qualify for long term capital gains rates, you must hold the asset you’re selling for at least a year and a day. So if you sell your Apple stock for a $100k gain at the 11 month mark, you will pay at least 10 percentage points or $10,000 more in taxes than you would if you held it for a year and a day before selling. This is why we hear all the time about holding for at least a year.
The way your taxes work is that your wage income stacks up first, which is assessed at the Tax Bracket column rates. Then you add your capital gains. Your capital gains begin in the same row as where you wage income leaves off and continues to increase the income total until it spills into the next bracket, and so on.
Taxes While Working
So let’s say you and your spouse each earn $50k a year. That puts you at $100k total a year and after your standard deduction of $12,600, you’re showing a total income of $87,400. If you sell any stocks for a long term capital gain (i.e. you’ve held it for over a year), you are paying 15% federal income tax on each dollar of gain. You’ve probably lived under this understanding of capital gains tax rates your entire working life.
Taxes While Retired
But when you retire and have zero income, you will fall under the zero percent long term capital gains rate. Your zero dollars of wage income stacks first, then your capital gains come in. Since you have zero income, ever single dollar in the bracket can be used for cap gains, plus your standard deductions. That means $87,900 ($75,300 plus your standard deductions of $12,600).
Think you can live on less than $87,900 a year? I do. And that means a zero percent federal income tax. Luckily for you, the brackets are adjusted for inflation every year, so you can rest assured that you will be able to pull an amount out each year equal in ‘purchasing power’ to past years.
If for whatever reason you do need more than $87,900 per year, the very next dollar would then be taxed at the marginal rate of 15%. Not bad if you can keep the amount close to that threshold.
For most of us office cogs, our cap gains have always been taxed at 15%. Look at that chart again: anything between $75,300 of household income to $466,950 (excluding deductions) will be taxed at a 15% capital gains tax rate. It would be surprising if we hadn’t built in 15% taxes into our projections.
But good news – your nest egg needs are actually 15% larger than you actually need. That’s probably several hundred thousand dollars less you have to stash away for federal income tax. That’s probably years of additional freedom you get back! Not bad for 3 minutes of reading.