Let me start by saying that this strategy won't apply to everyone - it requires a pretty significant nest egg. But with the proper planning, a 0% tax rate is within reach (pending no changes in the tax code). To keep it simple, I'm going to try and only mention three tax terms. The relevant ones here are ordinary income, long-term capital gains and qualified dividends.
Ordinary income tax is your normal tax rate. It's the bracket you see once a year at tax time, saying you have to pay X%. Long-term capital gains are gains from investments you have held over one year such as stocks or real estate. Long-term capital gains are taxed at a lower rate than ordinary income. For example, if you are in a 25% (ordinary income) tax bracket, you will pay 15% tax on capital gains. Finally, qualified dividends are dividends that receive the same tax treatment as long-term capital gains. In general, most dividends from US corporations are qualified. See that wasn't so bad.
If you look at the capital gains tax bracket, you will notice the lowest tier is actually 0%. The 0% bracket applies to investment income up to $37,650 for individuals and $75,300 for those who are married. Yes you can make 75,300 in long-term capital gains each year and pay $0 in federal income tax. 75,300 tax free is roughly equivalent to earning 100k taxed. In addition, you can make up to $10,350 in ordinary income if you are single and $20,700 if you are married and pay no tax. This is because everyone is eligible for the standard deduction of $6,300 and the personal exemption of $4,050 (2016 rates). Additional deductions will let you make more and still pay no tax.
2016 Capital Gains Tax Bracket from Charles Schwab
So how do you go about reaching a 0% tax rate? The easiest way is to keep your money in accounts in which you pay tax up front - think Roth IRA because you won't pay tax when you withdraw. You can withdraw your contributions from a Roth at any time, but you cannot withdraw your investment gains without penalty until you have reached retirement age (there are exceptions). Keep other assets in a taxable investment account where long-term gains will be considered capital gains.
Note that the most popular investment vehicle, the 401(k), causes problems because 401(k) withdrawals are taxed as ordinary income. The way around paying tax on these withdrawals is with Roth conversions. 401(k) contributions are taxed as ordinary income when you withdraw, but as I showed above, you can have $10,350 (single) or $20,700 (married) in ordinary income and pay no tax. As long as your yearly 401(k) conversions to a Roth and other ordinary income are under the thresholds you can avoid all tax liability while still making up to $75,300 in capital gains.
Here is how I plan on achieving a 0% tax bracket. First let me note that I do not plan on working to 65, so I do not anticipate social security payments or the required minimum distributions affecting my tax situation. I do plan on retiring before 40 with only a 401(k) and income from a taxable investment account. I will not be directly contributing to a Roth IRA in my working years! (I'll explain).
By maxing out my 401(k), I avoid $18k being taxed at 25% or $4,500. Down the line when I reach financial independence, I can convert $20,700 of ordinary income each year tax free (this amount goes up each year for inflation) to a Roth IRA and still earn up to $75,300 in investment income. By converting to a Roth, I avoid the early distributions penalty of 10%. I also end up paying a total of 0% in income tax on retirement contributions because this ordinary income is offset by the standard deduction I mentioned above. There is a five-year rule with Roth conversions where you must pay the 10% early withdrawal penalty unless you wait five tax years. After five years following the conversion, you can withdraw the converted amount without penalty. I can also withdraw early from a 401(k) using what the IRS calls substantially equal periodic payments and avoid any penalty (this works for Roths as well), there are some restrictions. These options will allow me to pay 0% tax and still access my money prior to the mandated retirement age.
If I had contributed to a Roth IRA or Roth 401(k) like every financial expert would advise a young person such as myself, I would be paying 25% tax each year on $18,000. By contributing to a 401(k) and sticking with my withdraw strategy, I will pay 0% tax on retirement contributions. By avoiding $4,500 in tax each year for 10 years and investing it at 6% interest, I end up saving $70,000!
In summary, upon retirement I can avoid paying tax on my 401(k) by converting $20,700 to a Roth IRA each year and I can make up to $75,300 each year in capital gains and qualified dividends in my "taxable" investment account and still pay 0%. By not working, my top tax bracket drops from 25% to 0%. For more on my early retirement plan see this article.
Travel Money
Analyst’s Disclosure: I am/we are long VTR, EPD, HASI, OHI, STAG, CCP, TD, TERP, GILD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
