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Getting to Zero

Michael Perry

AFTER YOU QUIT the workforce and before you start Social Security, you may find yourself with little or no taxable income. As many financial experts have pointed out, this can be a great time to convert a traditional IRA to a Roth and pay taxes at a relatively low rate.

But here’s another tax-savings opportunity to consider: If you have winning stocks and funds in your regular taxable account, this period can also offer the chance to realize long-term gains and pay taxes at a 0% federal rate. The key: Keep your taxable income low, including paying attention to capital gains distributions from your mutual funds. Those distributions may leave you with less room to realize gains at a 0% rate.

How might this work in practice? Let’s take the example of Bob and Jane, a retired couple not yet receiving Social Security. They collect a $30,000 annual pension. In 2020, their taxable investments produced $2,000 in interest, $10,000 in qualified dividends and $10,000 in long-term capital gains fund distributions. Assuming these numbers are the same this year, Bob and Jane would be looking at $52,000 in total income. Result: They could intentionally realize another $53,900 in long-term capital gains, bringing their total income to $105,900—and pay nothing in capital gains taxes.

If they take that $105,900 and subtract a married couple’s $25,100 standard deduction, they would be left with taxable income of $80,800. (The figures for those filing as single individuals would be half these levels.) As long as their total taxable income doesn’t breach that $80,800 threshold, any long-term capital gains—whether distributed by their mutual funds or the result of selling winning investments—would be taxed at 0%.

A key problem: It’s highly unlikely that Bob and Jane’s numbers are going to be the same this year as in 2020, and most can’t be known in advance. Yes, the pension amount is probably fixed, but it’s harder to know precisely how much in interest and dividends they’ll receive during the year, and next to impossible to know what capital gains will be paid out by their mutual funds. Still, they can anticipate 2021’s numbers will be at least somewhat similar to 2020’s, and then finetune their calculations closer to year-end. Here’s what they’ll need to pay attention to:

  • Pension. Bob and Jane should know the precise amount of pension income they’ll receive in 2021, though the amount may be higher than 2020 if the pension is inflation-linked.
  • Dividends and interest. They can know with fair certainty the interest payments they’ll receive, as well as what dividends they’ll receive from individual stocks. But they should check near year-end.
  • Fund capital gains distributions. Last year’s distributions are, alas, a poor predictor of this year’s. Instead, Bob and Jane will want to look out for the fourth-quarter announcements from their funds, detailing the capital gains that the funds plan to distribute by year-end.
  • Any capital losses realized in 2021. These could be used to offset gains.
  • Any new income, potential tax deductions larger than the standard deduction, or other unexpected factors that could change the math.

By waiting until the fourth quarter to realize capitals gains, Bob and Jane can know what their total income and losses from various sources will be for the full year. They’ll then be able to calculate with some precision how much in long-term capital gains they can realize at the 0% tax rate. What if they realize a bit more? The additional gains would be taxed at 15%. This would only apply to those gains over and above the $80,800 taxable-income threshold, so it wouldn’t be the end of the world.

Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. His previous articles were Working My Losses and An Appreciated Gift

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