First, let’s start with a brief overview of what capital gains are. Capital gains are profits earned from the sale of an asset, such as stocks, real estate, or artwork. If you sell an asset for more than you paid for it, the difference between the purchase price and the sale price is your capital gain. It is important to note that for investment accounts, the capital gains rate applies only to taxable accounts, such as brokerage accounts. Investments held in tax-deferred accounts or retirement accounts, such as traditional IRAs, Annuities, and 401(k)s, are subject to different tax rules.
Now, let’s talk about the different tax rates that can apply to capital gains. In the United States, capital gains are taxed at either a short-term or long-term rate, depending on how long you held the asset before selling it. Short-term capital gains, which are profits from the sale of an asset held for one year or less, are taxed at your ordinary income tax rate. Long-term capital gains, which are profits from the sale of an asset held for more than one year, are generally taxed at a lower rate than short-term gains.
However, if you’re in the lowest income tax bracket, you may qualify for a special 0% long-term capital gains tax rate. The 0% long-term capital gains tax rate was established by President Bush’s Jobs Growth and Tax Relief Reconciliation Act of 2003, but it was not implemented until 2008. For the 2023 tax year the 0% bracket increased for incomes between $0-$44,625 and married couples filing jointly between $0-$89,250.
So, how does this work in practice? Let’s say you are retired but before retirement you bought 1000 shares of stock for $50,000 five years ago, and today you sell those shares for $100,000. That’s a long-term capital gain of $50,000. Now because of retirement you have a pension of $30,000 and no other current taxable income for the year. If you are filing a joint return with no other taxable income, then that long-term capital gains will “stack on top” of your pension income. As a result, your combined income falls under the $89,250 threshold which for 2023 is a 0% capital gains tax bracket. This means you won’t owe any federal income tax on that gain! If you had a capital gain that exceeded that threshold, then only the gain ‘spills-over’ into the next bracket would be subject to the capital gains tax which currently resides at 15%.
It’s worth noting that state taxes may still apply to your capital gains, even if you’re in the 0% federal tax bracket. Additionally, if you have other sources of income besides capital gains, you’ll need to factor in those earnings when determining your overall tax liability. If you have Social Security income then adding capital gains might not result in a capital gains tax but it could trigger taxability of your benefits (more on that later).
It’s also important to remember that the 0% long-term capital gains tax rate is not a permanent feature of the tax code. Congress can and has made changes to the tax rates and brackets in the past, so it’s possible that this rate could be modified or eliminated in the future.
Overall, the 0% long-term capital gains tax rate can be a valuable tax break for individuals with lower incomes who have investments that have appreciated over time. If you think you might qualify for this rate, it’s a good idea to consult with a tax professional to make sure you fully understand the mechanics of how the 0% rate applies.
*Information provided should not be relied upon for tax, legal, or accounting advice, as it is intended for informational purposes only. You should consult your own tax, legal, and accounting professionals before engaging in any transactions.