Pay No Taxes! The 0% LTCG Tax Bracket

Did you know it’s possible to pay 0% in taxes? I sure didn’t!

It’s true. You can pay lower to no taxes by taking advantage of the favorable long-term capital gains (LTCG) taxes on investment income.

This is how billionaires like Warren Buffet have a lower tax rate than his secretary!

As a high-income earner, taxes will be your biggest ongoing expense so understanding and taking advantage of any tax savings will give you a tailwind to achieving financial freedom.

A brief history lesson: the LTCG tax rates were created under the Jobs and Growth Tax Relief Reconciliation Act of 2003 and made permanent under current law as part of the American Taxpayer Relief Act of 2012.

There are 3 main LTCG tax brackets: 0%, 15%, and a maximum of 20% based on your total taxable income for federal taxes (your Adjusted Gross Income (AGI) minus the standard or itemized deduction).

• Note: for high-income earners, there is an additional 3.8% Medicare surtax (the NIIT) that increases part of the 15% LTCG tax bracket and the entire 20% LTCG tax bracket. This effectively creates 4 LTCG tax brackets: 0%, 15%, 18.8%, and 23.8%.

Keep in mind that the lower LTCG tax rates only apply to certain types of investment income like long-term capital gains and qualified dividends (see the section below on how to qualify for LTCG tax rates).

Understanding how the LTCG taxes work can save you thousands or even allow you to earn investment income while paying 0% in federal taxes!

Qualifying For Lower LTCG Tax Rates

Not all investment income can qualify for lower LTCG tax rates.

The two main things to remember are you want as much of your income to come from 1) long-term gains and 2) qualified dividends as these will save you money in taxes.

Short-Term vs. Long-Term Capital Gains

To qualify for lower LTGG tax rates, you must sell an asset (real estate, stocks, bonds, cryptocurrencies, cars, precious metals, jewelry, etc.) that you’ve owned for more than one year.

If you sell an asset that you’ve owned for less than a year, it will be considered a short-term capital gain and will be taxed at your regular income tax rates. In other words, short-term capital gains face the same taxes as money you earn from your job or self-employment.

As shown above, the LTCG tax rates are much more favorable which shows that the government incentivizes long-term investing and gives a tax benefit on the earnings from those investments.

• Note: For investments sold at a loss, you can use tax loss harvesting to use those losses and offset capital gains that you have in the future.

Qualified vs. Non-Qualified Dividends

Dividends are not all equal in the eyes of the IRS. They are split into qualified or non-qualified dividends and are taxed at different rates.

Most diversified index funds or ETFs are considered tax-efficient because they mostly pay qualified dividends which are taxed at lower LTCG tax rates if you hold the stock for more than 60 days.

Non-qualified (called ordinary dividends) mostly come from investments that are not stocks, such as savings accounts, money market accounts, CDs, REITs, and employee stock options. These dividends are taxed at the highest ordinary income tax bracket that you fall into.

• Note: The IRS calls dividends “ordinary” or “qualified.” Keep in mind that qualified dividends are a part of your total ordinary dividends, but not all ordinary dividends are qualified dividends.

Between the two, you should always try to earn as many qualified dividends from your investments as they are clearly the more favorable tax options.

How The LTCG Taxes Work – Mechanics Of Stacking

When you have both ordinary income (salary, tips, bonuses, etc.) as well as long-term capital gains, the stacking mechanics come into play.

When the IRS calculates your taxes, it uses a series of steps to “stack” your income:

• First, it takes all your ordinary income and applies any tax deductions like the standard deduction
• Second, it applies the standard income tax brackets to your taxable ordinary income
• Third, it adds LTCGs on top of your taxable ordinary income (if ordinary income is lower than your tax deductions, any remaining deductions are applied to LTCGs)
• Lastly, it applies the LTCG tax brackets to your LTCGs

This sequencing of steps is actually the most beneficial (thanks IRS!) as ordinary income, which is taxed at higher rates, is reduced first by tax deductions before any LTCGs, which already have more favorable tax rates.

• Note: LTCG tax rates are for federal taxes only and do not account for any state or local taxes that may be due depending on where you live.

Example 1: Ordinary Income and LTCG Income

Let’s meet Henry and Henrietta, a married couple who earns $100,000 in combined salary, working for half the year before a sabbatical.

They take the standard deduction of $27,700 and realize $16,950 of LTCGs by selling some stock from their after-tax investment account to fund their sabbatical.

• Their taxable ordinary income is $100,000 – $27,700 = $72,300.
  • $22,000 is taxed at the 10% bucket ($2,200) and the remaining $50,300 is taxed at the 12% bucket ($6,036).

• Their taxable LTCG income is $72,300 + $16,950 = $89,250.
  • Since the $89,250 falls within the 0% LTCG tax zone (shown in yellow below), they pay $0 on their $16,950 of capital gains!

• Their total taxes due on ~$117K of income is just $8.2K (a ~7% effective tax rate). Not bad! But there’s a way to pay 0% in taxes. Let’s create another scenario.

Example 2: Only LTCG Income

After their sabbatical in Southeast Asia living on the white sand beaches of Bali, sipping on fresh coconut juice, and feasting on local lobster, Henry and Henrietta became hooked on vagabonding.

They aggressively hit their ideal saving rate, invested in tax-efficient stock index funds, and grew their investment portfolio to generate $100,000 in qualified dividends a year. They decide to pause their careers and set off on an adventure while they are still young, excited, and full of energy.

• Their taxable ordinary income is $0 (because they left their jobs!)
• Their taxable LTCG income (from qualified dividends) is $100,000 – $27,700 standard deduction = $72,300.
  • Since the $72,300 falls within the 0% LTCG tax zone, they pay a 0% effective tax rate on all of their income!
  • A $0 tax bill on a $100,000 budget to travel the world together and make life-changing memories! Amazing!

Tax Gain Harvesting

We mentioned tax loss harvesting, but another powerful strategy (that is not as well known) is tax gain harvesting when you are in the 0% LTCG tax bracket.

Tax gain harvesting is simple: sell your current investment which has a long-term capital gain and buy it back immediately to lock in the higher purchase price as your new tax basis. The whole process takes less than 30 seconds if done with a freely traded ETF index fund when the stock market is open.

• Note: tax gain harvesting also avoids the “wash sale” rules that only apply to tax loss harvesting, so you do not have to deal with a waiting period to buy back the investment that you just sold.

The gain you realized counts as “income” for federal tax purposes, but since you qualify for the 0% LTCG tax, you can pay the 0% rate on your gain and lock it in forever! See how this works below.

Example 3: Roth IRA Conversions And Tax Gain Harvesting

Henry and Henrietta are now residents of Bali.

They realized they could live comfortably on only $40,000 a year, but could still take advantage of Roth IRA conversions and tax gain harvesting to continue saving money for when they decide to come back home.

They earn $40,000 of qualified dividends, sell ETF index funds to realize $49,250 of long-term capital gains in their after-tax investment portfolio, and take advantage of Roth IRA conversions equal to the standard deduction of $27,700 using their 401Ks from their previous jobs.

• Their taxable ordinary income is $27,700 from the Roth IRA conversion (which counts as income for tax purposes), which is reduced to $0 by the standard deduction
  • The Roth IRA conversion allows them to pay a 0% tax rate now (so the conversion is tax-free!) and also lock in tax-free investment gains and withdraws from the Roth IRA in the future when they’re older! Similar concept to the ultimate tax-protected investment account.

• Their taxable LTCG income (from qualified dividends and sale of stocks) is $89,250.
  • They pay $0 on $40,000 of dividend income that can fund their living expenses in Bali.
  • They also pay $0 on $49,250 of LTCGs, forever locking in the higher tax basis for their stock investment that they immediately buy back because they are long-term investors.
  • Since the $89,250 of total taxable income falls within the 0% LTCG tax zone, they still pay no taxes… mind blowing!

Takeaways On The 0% Tax Rate

The main lesson here is that US tax laws favor those who earn a lot of investment income. They penalize the working rich who pay the highest rates of income taxes on their earned income (which is also subject to additional FICA taxes).

Warren Buffet has a lower tax rate than his secretary because a large part of his income comes from long-term capital gains and dividends that qualify for much lower tax rates. His secretary is a W2 employee who is taxed at higher rates for her income despite her net worth being a tiny fraction of Warren Buffet’s!

While the scenarios here are all made up, they teach us a lot of creative ways to understand and take advantage of possible tax savings.

Hypothetically, without any ordinary earned income, an individual and married couple can amass a tax-efficient index fund portfolio of up to ~$3.7 million and ~$7.4 million (assuming ~1.6% dividend yield), respectively, and pay no federal taxes on their dividend income.

This means that an individual can earn up to $58,475 ($44,625 0% LTCG limit + $13,850 standard deduction) and a married couple can earn up to $116,950 ($89,250 + $27,700) in investment income and still qualify for the 0% LTCG tax rate!

Can you live off ~$58K a year as a single person or ~$117K a year as a couple, tax-free?

While you may not be able to quit your job (at the moment) and live on passive investment income, you can apply the principles by loading up on tax-efficient stocks and holding investments for at least a year before selling them at a profit for lower tax rates.

Younger folks who have eligible capital gains (even from cryptocurrency) can utilize this strategy to lock in favorable tax rates before they hit their higher earning years.

There is a scenario for everyone to benefit from the lower LTCG taxes.

Whether you are taking a sabbatical, experiencing a layoff, or deciding to pursue an unpaid volunteering project, you can take advantage of any lower-income years by tax gain harvesting to fill the 0% LTCG tax bracket and keep the rest of your investment gains deferred into the future.

​​At the end of the day, this post is just a fun little thought experiment and nothing here is tax advice. For high-income earners, it’s wise to invest time in tax planning as taxes will be your biggest ongoing expense.

I’ve been able to use strategies such as tax-arbitraging to reduce cost of living and aggressively save towards financial freedom.

Knowing that the 0% LTCG tax rate exists and how to use it to your advantage is another powerful tool in your personal finance toolbox!