You might be thinking that since you finally made it to Financial Independence and are living on the 4% Rule that your tax paying days are over.
Unfortunately, the bad news is, is that you still need to file and pay taxes every year.
The good news is, is that you should be able to pay very little or possibly no taxes if you’re smart about how you take your gains from your appreciating assets.
Before we get too far into the weeds, I want to clarify that I am not a tax professional and this is not tax advice. You should always consult a tax professional for tax planning and tax filing.
Now that that’s out of the way, let’s talk about the tax implications of being Financially Independent.
For most people, if you are financially independent or are living on the 4% rule, you will have assets that are (hopefully) growing in value, paying dividends or both.
Uncle Sam is going to want his piece of this so it’s important to do proper tax planning and understand how much you can claim with a standard deduction each year as well as what your capital gains taxes will be.
The easiest way to get started is to first separate your income into Ordinary Income and Long Term Capital Gains.
Short Term Capital Gains and Ordinary Income are taxed at the same rate, so for our purposes today, they are the same thing and should be grouped together.
Ordinary Income vs Long Term Capital Gains
- Wages from a job
- W9 Contractor Work
- Social Security Benefits
- Ordinary Dividends
- Bank Interest
- Assets held for less than 1 year
Now that you have your income separated, it’s time to find out your standard deduction:
2023 Standard Deduction Amounts: (Returns Normally Due April 2024)
|2023 Standard Deduction
|Single; Married Filing Separately
|Married Filing Jointly; Qualifying Widow(er)
|Head of Household
Captial Gains Tax Rate Formula
The formular for figuring out how much of your income is subjecet to LTCG is pretty straight forward:
Subtract Standard Deduction
Plus Long Term Capital Gains
Long Term Capital Gains Example:
Jimmy files as “Single” and takes the 2023 deduction of $13,850.
He has ordinary income (wages, short term gains, dividends, etc.) of $15,000.
He has Long Term Capital Gains of $18,000
Ordinary Income $15,000
Subtract Standard Deduction -$13,850
Total = $1,150
Plus Long Term Capital Gains $18,000
$19,500 taxed at 0% (See LTCG Tax Bracket)
With the 0% Long Term Capital Gains amount at $44,625 for 2023. Jimmy could have “Realized” $44,625 – $1,150 = $43,475 of gains at 0%!
2023 Long Term Capital Gains Tax Rates
|Up to $44,625
|$44,626 – $492,300
|Married filing jointly
|Up to $89,250
|$89,251 – $553,850
|Married filing separately
|Up to $44,625
|$44,626 – $276,900
|Head of household
|Up to $59,750
|$59,751 – $523,050
What Does it Mean to Realize Capital Gains?
To realize capital gains means to sell or dispose of an asset at a price higher than its original purchase price, resulting in a profit.
Capital gains are typically associated with investments such as stocks, bonds, real estate, or other capital assets. The gain is “realized” when the asset is sold, and the profit becomes tangible.
For example, if you buy a stock for $1,000 and later sell it for $1,500, you have realized a capital gain of $500. On the other hand, if the selling price is lower than the purchase price, it results in a capital loss.
Realizing capital gains has tax implications. In many tax systems, you are required to report capital gains on your tax return, and you may be subject to capital gains taxes. The tax treatment can vary based on factors such as the holding period of the asset and the specific tax laws in your jurisdiction.
Why you should “Realize” Long Term Capital Gains every year
Since the long term capital gains rate is 0% for up to $44,625, it makes sense to “realize” as much of these gains as possible each year. This allows you to maximize your tax efficiency and potentially reduce your overall tax liability.
By strategically realizing long-term capital gains within the tax-free threshold, you can take advantage of the 0% tax rate on those gains. This means that, up to the specified limit, you won’t owe any additional taxes on the profit made from selling qualifying assets held for more than one year.
This approach can be especially beneficial for investors looking to optimize their financial planning and minimize the impact of taxes on investment returns. Keep in mind that individual financial situations vary, and it’s advisable to consult with a tax professional or financial advisor to develop a personalized strategy based on your specific circumstances.
For example, if you have $500,000 in a brokerage account and it increases by 10% then you will have $50,000 in unrealized capital gains. Each year you can “realize” over $40,000 in LTCG so it most cases it makes sense to sell the assets in your account, realize the gains, and then you can buy right back in at the current price.
How to Realize Long Term Capital Gains
Realizing your gains basically just means selling your assets that have increased in value. This would be the opposite of a theoretical gain or a paper gain.
Let’s say that you bought 10 shares of Tesla stock for $100.00 and now each share is worth $300.00. If you don’t sell the shares, then the gain is still a paper gain and no taxes will be incurred.
But if you do sell your 10 shares of stock then you will have a “realized” gain of $200.00 x 10 shares = $2,000.
If you still want to own the stock, then you can immediately buy it back at $300.00.
Now your cost basis is $300.00 and if the stock goes up to $500.00 you decide to sell, then you will have another gain of $200.00 per share. Since you are allowed to “realize” a certain amount of Capital Gains each year, you can greatly reduce your tax liablity by realzing Long Term Capital Gains each year.
Long Term vs Short Term Capital Gains
The primary difference between short-term and long-term capital gains lies in the duration for which an investment is held before it is sold.
Here are the key distinctions:
Short-Term Capital Gains: Refers to profits generated from the sale of an asset that has been held for one year or less.
Long-Term Capital Gains: Refers to profits from the sale of an asset that has been held for more than one year.
Short-Term Capital Gains: Typically taxed at the investor’s ordinary income tax rates, which can be higher than long-term capital gains rates.
Long-Term Capital Gains: Generally qualify for preferential tax rates, which are often lower than ordinary income tax rates. The specific rates can vary based on the investor’s income and the type of asset.
Short-Term Capital Gains: Taxed at the individual’s ordinary income tax rates, which can range from 0% to the highest income tax bracket.
Long-Term Capital Gains: Have separate tax rates, typically 0%, 15%, or 20%, depending on the taxpayer’s income.
Short-Term Capital Gains: Often associated with more frequent trading and shorter investment horizons.
Long-Term Capital Gains: Typically associated with a buy-and-hold strategy, as holding investments for a longer duration may lead to more favorable tax treatment.
Short-Term Capital Gains: May result in higher tax liabilities due to being taxed at regular income tax rates.
Long-Term Capital Gains: Investors may strategically plan to hold assets for more than one year to benefit from lower tax rates.
Understanding the difference between short-term and long-term capital gains is crucial for investors, as it can impact their overall tax liability and influence their investment decisions based on their financial goals and tax planning strategies.
The most important thing to remember with Financial Independence is that your tax filing days are not over. In most cases you will be withrawing from your assets for living expenses and whether you’re withdrawing 4% or just living off of dividends, there will be tax implications.
Every year, the IRS let’s you make a certain amount of income without paying any tax. This can be through the standard deduction which can be applied to your Ordinary Income and it can also be in the form of Long Term Capital Gains.
If you are not “realizing” some of your Long Term Capital Gains each year, then you might be stuck with a huge tax bill down the road.