In early retirement we plan to live off of our investments. This means that our primary sources of income are going to be long term capital gains and, to a lesser extent, dividends. It therefore behooves us to understand precisely how taxation of long term capital gains works in the U.S., and how much of our annual withdrawal we can expect to hand over to the tax man.
This article focuses on federal taxes only. Some states have favourable rates for long term capital gains while others treat them no differently than ordinary earned income. Be sure to factor in your state taxes as well.
Introducing the Hypothetical-BITAs
We will explore how taxation of long term capital gains works by following the fortunes of a couple that we will call the Hypothetical-BITAs (the H-BITAs).
Mr. and Mrs. H-BITA retired early, at the age of 42. They have one child. Their tax designation is married, filing jointly (a.k.a. MFJ). They plan to withdraw $60,000 a year from their investment portfolio. Their taxable brokerage account throws off $5,000 in qualified dividends a year. The H-BITAs prefer to spend their days in the hammock sipping margaritas, so they make no earned income.
While their investments are spread across two traditional IRAs, two Roth IRAs and one taxable brokerage account, at the start of their retirement journey they plan to leave their IRAs untouched, and will withdraw the $60,000 from their taxable brokerage account.
Lets help the H-BITAs figure out how much they owe the taxman.
Computing Taxable Income
In order to figure out your marginal tax bracket for capital gains, you first need to figure out your marginal federal income tax bracket. And to do that, you first need to know how much taxable income you have.
While long term capital gains and qualified dividends are not taxed the same way as ordinary income, they do contribute to the computation of your Adjusted Gross Income (AGI), and hence to to the computation of taxable income and your marginal income tax bracket. The marginal income tax bracket is, in turn, used to derive the marginal LTCG taxation rate.
The H-BITAs plan to withdraw $60,000 from their taxable brokerage account. Let’s assume that the cost basis of the $60,000 withdrawal is $35,000. This means that they have long term capital gains (LTCGs) of $25,000.
So the H-BITAs have
- $0 earned income +
- Qualified dividends of $5000 +
- LTCG = $25,000
That brings their income to a grand total of $30,000.
Once you know what your total income is, the next step is to figure out how much of that is subject to taxation. To do that you have to subtract out any deductions and exemptions that you qualify for.
For simplicity we are assuming only standard deductions. The amount of deductions could be higher if you happen to be itemizing your deductions.
What federal income tax bracket do the H-BITAs land in with income = $30,000?
Standard deduction in 2017 for a couple, MFJ, is $12,700. They also get a personal exemption of $4,050 each.
So the H-BITAs taxable income = $30,000 – $12,700 – $4050 * 2 = $9,200.
Determining the Marginal Tax Rate for your Long Term Capital Gains
Now that you know how much taxable income you have, you can determine your federal income tax bracket and then use that to determine the marginal tax rate for your long term capital gains.
With taxable income of $9,200 the H-BITAs, who are MFJ, fall in the 10% federal tax bracket.
Now that you know your federal income tax bracket, you can use that to determine your long term capital gains marginal tax rate.
This diagram is a slight simplification, because I’m not taking the potential 3.8% Medicare tax on net investment income into account.
If your taxable income falls in either the 10% or the 15% income tax brackets, you pay 0% on your LTCG. Tax brackets from 25% to 35% pay 15% on their long term capital gains. Taxpayers in the highest income tax brackets owe 20% on their long term capital gains. Like income taxes, LTCG taxes are progressive in nature.
The H-BITAs have a 10% marginal federal income tax rate, and so their LTCG marginal tax rate is 0%.
Computing Tax Owed
Now you are ready to figure out your tax bill. The key things to remember are:
- You start filling your tax brackets with ordinary income that is not taxed at any preferential rate.
- You apply your federal income tax rates progressively to this income.
- Once you run out of ordinary income, you stack your ‘special’ income (long term capital gains and qualified dividends) on top of your regular income.
- Once you switch from ordinary income to special income, you also switch from using the income tax rates to using the LTCG tax rates.
A picture is worth a thousand words:
In the picture ordinary income fills up the 10% bracket and a little of the 15% bracket. Then we start to stack LTCG and qualified dividends on top and switch to using the LTCG brackets and tax rates for this income. So some of the LTCG get taxed at 0% and then the rest get taxed at the marginal rate of 15%.
To determine income tax bracket consider all taxable income, ordinary before preferred.
To determine income tax rate consider the kind of income being taxed.
In the diagram above only a part of the LTCGs get taxed at the 0% rate, because ordinary income is filling up most of that bracket, and that ordinary income is being taxed at the income tax rates of 10% and 15%.
The H-BITAs have no ordinary income. They have $9,200 of taxable income (LTCGs plus qualified dividends) that will be taxed at the marginal LTCG tax rate determined in Step 4, which is 0%.
The H-BITAs can live on the princely sum of $65,000 a year, which includes LTCGs of $25,000 and qualified dividends of $5,000, and they will owe no federal taxes.
The Hypothetical-BITAs Get Complicated
For fun let’s run through steps 1 – 5 again, but this time in an alternate universe where the H-BITAs have slightly more complicated finances.
Introducing Mr. and Mrs. H-BITA once again. They have one child. Their tax designation is married, filing jointly (a.k.a. MFJ). They plan to withdraw a whopping $85,000 a year from their investment portfolio. Their taxable brokerage account throws off $8,000 in qualified dividends a year. In this scenario, Mrs. H-BITA has retired, but Mr. H-BITA works part time to supplement their retirement income. He brings in $60,000 in earned income. Let us also assume that the cost basis for the $85,000 withdrawal is $40,000.
Lets run through the 5 steps with the H-BITAs again:
The H-BITAs now have a total of $113,000 ($60,000 + $45,000 + $8,000) in income.
The H-BITAs taxable income is:
$113,000 – $12,700 – $4050 * 2 = $92,200.
With taxable income of $92,200, and MFJ, the H-BITAs land in the 25% federal income tax bracket.
A 25% income tax bracket gives the H-BITAs a marginal LTCG tax rate of 15%.
The H-BITAs have taxable income of $92,200, of which $53,000 are LTCGs and qualified dividends:
$18,650 is taxed at an income tax rate of 10%
$20,550 is taxed at an income tax rate of 20%
Now they are out of ordinary income, so they must switch the way they compute taxes.
The 0% LTCG bracket extends to $75,900. They’ve used up $39,200 of that bracket for ordinary income. So the first $36,700 of their LTCG will be taxed at 0%.
That leaves $53,000 – $36,700 to be taxed at 15%.
So, their total taxes are:
$1865 + $4110 + $2445 = $8420.
That gives them an effective tax rate of about 9.1%.
So with $113,000 in income (LTCGs + dividends + earned income) the H-BITAs owe $8420 in taxes.
We Conclude with an Excel Sheet
I am used to paying a small fortune in income taxes every year. Not so very long ago I had a duh moment. I use a running average of our annual expenses to figure out how large our Stash needs to be to support our desired withdrawal rate in early retirement. Guess what is included in our current annual expenses? Our current taxes. I had been planning for more than we needed, because I had failed to take into account the completely different tax landscape of early retirement.
I have created an excel sheet that performs steps 1-5 described in this post and computes total federal tax owed given income, dividends and long term capital gains. The sheet is available in the Bayalis Bag of Holding to all subscribers of this blog. The password to access the subscriber-only area is in the email that you receive from us.
Sign up to GET YOUR COPY OF THE LTCG TAXATION SHEET
When you get the excel sheet you won’t be able to edit my copy, so here is what you need to do to make your own:
Click on “File”, then “Make a Copy” to get a local copy of the spreadsheet in your own Google Drive. You will then be able to modify the sheet.
In my next post we will build on the model we put together today to help us figure out how to take advantage of any leftover tax space to do Roth conversions or some good old fashioned tax gain harvesting.