Have you ever wondered how the wealthy pay so little in taxes relative to their income? In fact, you may wonder do rich people even pay taxes? Truthfully, there are many methods to lower your effective tax rate, which is why when you make an income with two commas, it behooves you to hire a savvy accountant. Maybe you should take a page from their playbook and learn how to pay zero tax on your income as well.
But one of the more popular methods utilizes the different tax treatment of capital gains, or the profit received from the sale of an investment or property, compared to ordinary income.
The IRS taxes short-term capital gains at the equivalent of your marginal income tax rate. For long-term capital gains, they tax at 0%, 15% or 20%, depending on your annual taxable income.
As you can see from the chart below, if your income exceeds $510,300 and you can manage to hold an investment for longer than a year, it makes a lot of sense to do so. When you sell after a year, there’s a 17% difference in tax rate you’ll pay on your long-term capital gain.
Short-Term and Long-Term Capital Gains Tax Rates by Income for Single Taxpayers
|Income||Short-Term Capital Gains Tax Rate||Long-Term Capital Gains Tax Rate|
|$9,701 - $39,375||12%||0%|
|$39,376 - $39,475||12%||15%|
|$39,476 - $84,200||22%||15%|
|$84,201 - $160,725||24%||15%|
|$160,726 - $204,100||32%||15%|
|$204,101 - $434,550||35%||15%|
|$434,551 - $510,300||35%||20%|
|Short-term capital gains tax is the tax paid on profits from the sale of an asset held <1 year|
|Short-term capital gains tax rate is equal to your applicable federal marginal income tax rate|
After tax reform in 2018, the biggest spread comes in the in the $204,101 – $434,550 income range. This differential is 20% and the largest gap between short-term and long-term gains.
If you find yourself in this tax bracket, it makes the most sense to delay taking a capital gain until at least year has passed assuming the asset won’t dramatically decrease in value as a result.
The same table for married, filing jointly taxpayers appears below.
Short-Term and Long-Term Capital Gains Tax Rates by Income for Married, Filing Jointly Taxpayers
|Income||Short-Term Capital Gains Tax Rate||Long-Term Capital Gains Tax Rate|
|$19,401 - $78,750||12%||0%|
|$78,751 - $78,950||12%||15%|
|$78,951 - $168,400||22%||15%|
|$168,401 - $321,450||24%||15%|
|$321,451 - $408,200||32%||15%|
|$408,201 - $488,850||35%||15%|
|$488,851 - $612,350||35%||20%|
|Long-term capital gains tax is the tax paid on profits from the sale of an asset held >1 year|
|Long-term capital gains tax rate depends on your income range|
How to Pay Zero Tax – Why You Want Passive Income
If you need more evidence of why passive income is the best type of income after tax reform, look no further than the chart above.
Passive income, sometimes referred to as residual income, can receive the same tax treatment as long-term capital gains. This means money you earn from qualified passive activities receives preferential tax treatment, thereby making it a superior type of income compared to ordinary income. And if you see the upper end of the 0% tax range shown above, you’ll see just how to pay zero tax on your income: make it passive!
Naturally, passive income comes from passive activities. Non-passive activities (otherwise called active) are businesses in which the taxpayer works on a regular, continuous and substantial basis.
Passive income does not include salary, portfolio, or investment income. In general, the IRS considers an activity passive if it involves rentals or any business in which the taxpayer does not materially participate.
The IRS uses material participation as a test to meet the passive income standard. Some of the ways to meet the material participation categorization (and thus not have this activity qualify as passive) include:
- Being the sole participant in the business during the year
- Working at least 500 hours in the endeavor during the year
- Working at least 100 hours and as much as any other individual at the business during the year
- Working at least 100 hours in the activity and a total of more than 500 hours at all passive activities for the taxpayer
- Having materially participated in at least 5 of the past 10 tax years
- For personal services businesses, having materially participated in three previous tax years at any time
A final facts and circumstances test allows the IRS to consider whether you engaged in regular, continuous, and material participation in the activity during the year. However, you still need to work at least 100 hours in any circumstance.
How is Rental Income Taxed?
When figuring asking yourself, “how much tax do I pay on rental income?”, you should know the IRS considers income from rental activities as passive. Therefore, it disallows rental income as a loss you can take against your non-passive income. However, despite rental income being considered income from a passive activity, the tax code still taxes this income at ordinary income rates.
This means you cannot have a disallowed (passive) loss offset ordinary (active) income unless you meet the “Mom and Pop” exception.
For small landlords with modified adjusted gross income (MAGI) under $150,000 ($75,000 if married filing separately), they may deduct up to $25,000 in rental losses against their non-passive income. This amount phases out between $100,000 and $150,000.
If your MAGI exceeds $100,000 ($50,000 if married filing separately or single), the $25,000 maximum deduction amount ($12,500) is reduced by 50% of each dollar over $100,000 ($50,000). To illustrate, if your MAGI is $120,000, the maximum $25,000 deduction is reduced by $10,000 (50% * $20,000), leaving $15,000 available from the deduction against your ordinary income.
Assuming you don’t qualify as a real estate professional, this exception might benefit your tax bill come tax time each year.
A major difference used in the Mom and Pop exception is its use of the active participation standard, not to be confused with the material participation standard. Active participation is a less stringent standard and is intended to make it easier for individuals, who cannot be considered real estate professionals, to qualify for the Mom and Pop $25,000 rental loss deduction against ordinary income.
To qualify for active participation, the taxpayer must have a greater than 10% ownership interest in the property and participate in management decisions. Some examples include screening and approving tenants, agreeing to rental terms, and approving maintenance and service expenses for the property. This standard has no specific hour requirement.
Some other benefits of being a landlord are using MACRS depreciation and classifying the real estate under Section 1231 property rules. If you own multiple rental properties and are organized as a business, when you sell, you may need to file Form 8594, Asset Acquisition Form.
What Type of Passive Income Qualifies for Long-Term Capital Gains Treatment?
I should point out the importance of making sure your passive income qualifies for long-term capital gains treatment. As mentioned above, if you sell an asset held for longer than a year and realize a capital gain, the IRS treats this as a long-term capital gain.
Likewise, corporations can pay dividends, some of which are considered “qualified” and meet the long-term capital gains treatment. For reference, a dividend is generally considered qualified if it is paid on stock you held more than 60 days during the 121-day period that began 60 days before the ex-dividend date. This is the first date new investors are not entitled to receive the stock’s next dividend.
For any dividends not meeting those requirements, they are considered ordinary dividends and are taxed at ordinary income rates. Some other examples which do not satisfy the qualified dividend treatment are:
- Master limited partnerships (MLPs)
- Real estate investment trusts (REITs)
- Dividends paid on employee stock options
- Dividends paid by tax-exempt companies
- Dividends paid on savings or money market accounts
The Net Investment Income Tax
Another tax which you need to pay attention to is the net investment income (NII) tax. The IRS has the NII lay on top of your capital gains and applies to whichever is smaller: your NII (investment gains less investment losses and expenses) or the amount by which your MAGI exceeds the amounts listed below.
The income thresholds which make investors subject to this additional tax are $200,000 for single or head of household taxpayers, or $250,000 for taxpayers who file as married, filing jointly.
This means if you earn ordinary income of $250,000, NII of $100,000 and classify yourselves as married, filing jointly, you’ll pay $3,800 (3.8% of $100,000) on top of your 15% long-term capital gains tax rate. You may also have to pay state income taxes, depending on where you live. Swell, isn’t it?
What is the Saver’s Credit?
Another way to lower your tax liability is by taking advantage of the Saver’s Credit. The credit, formerly called the Retirement Savings Contribution Credit, gives a special tax break to low- and moderate-income taxpayers who choose to save for retirement.
The Saver’s Credit comes in addition to other tax benefits received from saving in a tax-advantaged account like an individual retirement account (IRA). If you qualify for this credit, it can reduce or even eliminate your tax bill.
Depending on your adjusted gross income and tax filing status, you can claim the non-refundable credit for 50%, 20% or 10% of the first $2,000 contributed during the tax year to a retirement account. The math behind that leads to 2018 Saver’s Credit claims of $1,000, $400, or $200, respectively.
Using the passive income you earned to contribute to a tax-advantaged account can further compound your ability to pay zero tax. The biggest credit amount goes to couples using the married, filing jointly status and can amount to $2,000.
Of note, if you or your spouse took a taxable distribution from your retirement account in the previous two years, this distribution reduces the size of the Savers Credit available to you.
Currently, the accounts which qualify for the Savers Credit are:
- 457 plan
- Simple IRA
- SEP IRA
- Traditional IRA
- Roth IRA
To be eligible for the credit, you must be 18+, cannot be a full-time student nor claimed as a dependent on someone’s tax return. The maximum adjusted gross income for Savers Credit eligibility in 2018 is $63,000 for a married, filing jointly couple, $47,250 for a head of household, and $31,500 for single taxpayers.
As your income increases, the Savers Credit phases out. For reference, see the Savers Credit table below for credit amount by filing status and adjusted gross income.
|Credit||Married, Filing Jointly||Head of Household||Individual|
To claim the Savers Credit, use Form 8880, Credit for Qualified Retirement Savings Contributions.
How to Pay Zero Tax – Use these Different Tax Preferences to Your Advantage
From the tables above, you can see from the federal level how to pay zero taxes by generating qualified passive income. Specifically for qualified passive income (long-term capital gains) tax rates in 2019, if you make $39,375 for single taxpayers and $78,750 for married, filing jointly taxpayers, you fall into the 0% tax rate.
Of course, these income levels are tax-free (not including the consequences of state taxes) if you don’t also make ordinary income above those levels plus your respective standard deduction to push you into the 15% long-term capital gains bracket.
In other words, if you make $12,200 (2019 standard deduction for single taxpayers) of ordinary income as a single taxpayer and $39,375 of qualified passive income ($51,575 total), you wouldn’t have any federal income tax liability. Likewise, for married, filing jointly taxpayers, they can have $24,400 (2019 standard deduction for married, filing jointly taxpayers) of ordinary income and $78,750 of qualified passive income ($103,150 total) to pay zero tax (federal income tax).
If you could find a way to generate that level of income in retirement (early or otherwise), you’d tell Uncle Sam to bugger off because it’s all yours to keep. You could find qualified dividend-paying investments which yield 2% and live federal income tax-free off of capital investments worth roughly $1,286,000 if you’re single or $2,573,000 if you’re married. For simplicity, let’s say $1.25 million and $2.5 million.
You could also buy qualified solar equipment with your passive income, thereby allowing you to claim the solar energy investment tax credit and lower your tax liability further.
Of course, you could also see how to pay zero tax and avoid federal income tax liability on some higher-earning qualified dividend investments on less capital investment. For example, a 5% qualified dividend investment would earn you the max free of federal income tax liability on $772,000 or $1,544,000 worth of capital investments for individuals and couples filing jointly, respectively. This could also come from selling assets held for longer than a year and realizing long-term capital gains.
If you want more federal income tax-free income, you could buy municipal bonds from your state and only pay state income taxes (if applicable).
And if you did earn ordinary income above the standard deduction and hold real estate, you’ve got more options available to you. This real estate investment might produce losses you could use to offset your ordinary income earned above the standard deduction if you qualify for the Mom and Pop exception above.
But the real advantage of lower long-term capital gains tax rates is if you end up generating more qualified passive income or long-term capital gains, the first $39,375 or $78,750 in gains are tax-free depending on your filing status and income level.
If you earn between $78,751 and $488,850 as a married, filing jointly taxpayer, you only pay 15% on passive income. Because of this, to the extent you can manage, you should consider generating as much qualified passive income as you can until you find your optimal level of financial independence.
About the Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey to reach a Millennial retirement and connect with and help others who share the same goal.
Some of my favorite things to discuss include investing in index funds, how to save money, travel hacking with help from the Reddit churning community, house hacking and optimizing the benefits of my condo vs. apartment living, and tax topics like the earned income tax credit, common tax deductions, tax reform in 2018, or other useful tax topics. I want this to be a journey for us all to learn how to make a lot of money and pursue the lives we want.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.