Be aware of these tax-free income opportunities

Dear Clients and Friends,

Do you know all the ways to collect tax-free income and gains? There are more than a few ways to do it. Here’s a summary of what we think are some of the best federal-income-tax-free opportunities for individual taxpayers.

Tax-free capital gains and dividends

In surprisingly wide sweet spots, the federal income tax rate on long-term capital gains and qualified dividends can be 0%. Here are some examples.

• Example 1: You’re married filing jointly with two dependent children. In 2023, you claim the $27,700 standard deduction. You could have up to $116,950 of adjusted gross income (AGI), including long-term gains and dividends, and still be within the 0% bracket. Proof: $116,950 – $27,700 = $89,250 of taxable income, which is the top of the 0% long-term capital gains bracket for joint filers for 2023.
• Variation 1: Say you’re divorced and file as a head of household. You have two dependent kids. In 2023, you claim the $20,800 standard deduction. You could have up to $80,550 of AGI, including long-term gains and dividends, and still be within the 0% bracket. Proof: $80,550 – $20,800 = $59,750 of taxable income, which is the top of the 0% bracket for heads of households for 2023.
• Variation 2: Now assume you’re unmarried with no dependents. In 2023, you claim the $13,850 standard deduction. You could have up to $58,475 of AGI, including long-term gains and dividends, and still be within the 0% bracket. Proof: $58,475 – $13,850 = $44,625 of taxable income, which is the top of the 0% bracket for single filers for 2023.

Definition of AGI: AGI equals the sum of your taxable income items reduced by the sum of above-the-line deductions for things like deductible contributions to a traditional IRA, self-employed retirement plan contributions, self-employed health insurance premiums, the deductible portion of self-employment tax, and alimony payments required by pre-2019 divorce agreements.

Itemizers: If your itemized deductions are greater than the standard deduction, your AGI, including long-term gains and dividends, could be even higher, and you would still be within the 0% bracket for those gains and dividends.

Income sheltered with capital losses is tax-free

Say you have incurred capital losses this year from stocks and mutual fund investments held in a taxable brokerage firm account or have a capital loss carryover from last year.

Join the club. Fortunately, capital losses have tax-saving value.

If you have a current-year net capital loss and/or a capital loss carryover into this year, you can use it to shelter capital gains plus up to $3,000 of income from other sources (salary, self-employment income, interest income, whatever), or up to $1,500 if you use married filing separately status. You can carry over any unused net capital loss into next year to shelter gains and income in 2024 and beyond.

Tax-free treatment for gain on inherited assets

If you inherit an asset like stock, mutual fund shares, or real estate, the federal-income-tax basis of the asset is stepped up to its FMV as of the date of your benefactor’s death (or six months after that date if the executor of your benefactor’s estate so chooses). If you sell the inherited asset, you won’t owe any federal capital gains tax except on appreciation that occurs after the magic date, if any.

Tax-deferred, like-kind real estate exchanges

You can postpone the federal income tax bill from selling appreciated real property by arranging for a like-kind exchange. Gain is deferred to the extent you purchase replacement property. Although not technically tax-free, you can use this strategy to defer gains indefinitely.

Tax-free small business stock gains

Qualified Small Business Corporations (QSBCs) are a special category of corporation, the stock of which can potentially qualify for federal-income-tax-free treatment if you sell it for a gain.

QSBC shares issued after 9/27/10 are eligible for a 100% gain exclusion, which equates to totally federal-income-tax-free treatment if you hold the shares for over five years before selling. When available, this break can be a huge tax saver. Contact us if you want more information.

Tax-free income accumulation and withdrawals from Roth IRAs

Unlike withdrawals from traditional IRAs, qualified Roth IRA withdrawals are federal-income-tax-free (and usually state-income-tax-free, too). A qualified withdrawal is one that’s taken after you’ve met both of the following requirements:

1. You’ve had at least one Roth IRA open for over five years.
2. You’ve reached age 59½, are disabled, or deceased.

Exemption from Required Minimum Distribution (RMD) Rules: Unlike with a traditional IRA, you do not have to start taking required minimum distributions (RMDs) from a Roth IRA after reaching age 72 (or face a stiff penalty).

Therefore, you can leave a Roth account untouched for as long you live. This important privilege makes the Roth IRA a great asset to set up, maintain, and eventually leave to your heirs, to the extent you don’t need the Roth IRA money to help cover your own retirement-age living expenses.

The trick is getting money into a Roth IRA. There are two ways to do that.

Make annual contributions: Making annual Roth IRA contributions makes the most sense if you believe you will pay the same or higher tax rates during retirement. You can avoid higher future federal income tax rates on Roth account earnings because qualified Roth withdrawals are federal-income-tax-free.

The downside is you get no deductions for Roth contributions. So, if you expect to pay lower tax rates during retirement, you might be better off making deductible traditional IRA contributions (assuming your income is low enough to permit deductible contributions), because the current deductions may be worth more to you than future tax-free withdrawals.

The maximum amount you can contribute for any tax year to a Roth IRA is the lesser of (1) your earned income for that year or (2) the annual contribution limit for that year.

Basically, earned income means wage and salary income (including bonuses), self-employment income, and alimony received under a pre-2019 divorce decree. For 2023, the Roth contribution limit is $6,500 ($7,500 if you’ll be age 50 or older as of year-end). This assumes you’re unaffected by the AGI-based phase-out rule. Ask us about that rule and if you are affected.

Important point: Your ability to make annual Roth contributions is unaffected by your age. You can keep making annual contributions as long as (1) you have enough earned income to back them up and (2) your contribution privilege is not wiped out by the phase-out rule.

Convert a Traditional IRA: You can convert a traditional IRA to Roth status. There is no income limitation on the conversion privilege. Even billionaires are eligible. That’s important, because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA.

However, it’s important to remember that a conversion will trigger taxable income, because the conversion is treated as a taxable withdrawal from your traditional IRA followed by a contribution to the new Roth IRA. So, you need to consider the federal income tax hit that will accompany a conversion. There may be a state income tax bill, too. So, please consult us before pulling the trigger on a conversion.

Tax-free withdrawals from Section 529 College Savings Plan accounts

Section 529 college savings plan accounts allow account earnings to accumulate free of any federal income tax. Then tax-free withdrawals can be taken to pay for the account beneficiary’s qualified college costs. State income tax breaks are often available, too.

The second big selling point is that 529 accounts can be used by individuals who can afford to make large initial contributions to get their college savings programs jump-started. Specifically, you can make a larger initial contribution and spread it over five years for federal gift tax purposes. That allows you to immediately benefit from five years’ worth of annual federal gift tax exclusions, currently amounting to $85,000 ($17,000 x 5), to quickly get your beneficiary’s college fund off the ground. If you’re married, your spouse can do the same.

Tax-free withdrawals from Coverdell Education Savings Accounts (CESAs)

You can contribute up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary – typically your child or grandchild – who has not reached age 18. A CESA is an account set up by a responsible person, which usually means you, to function exclusively as an education savings vehicle for the account beneficiary.

CESA earnings accumulate federal-income-tax-free. Then tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.

The catch: The privilege of making CESA contributions is phased out between modified adjusted gross income (MAGI) of $190,000 and $220,000 if you’re a married joint filer and between $95,000 and $110,000 for all other filers.

Tax-free Social Security benefits

Most individuals are taxed on between 50% and 85% of their Social Security benefits. But those with modest incomes can receive a bigger percentage (potentially up to 100%) federal-income-tax-free.

• If you’re a married joint filer, with provisional income below $32,000, 100% of your benefits are tax free. With provisional income between $32,000 and $44,000, you’ll be taxed on up to 50% of your benefits. Above $44,000, you could be taxed on up to 85%.
• If you’re unmarried with provisional income below $25,000, 100% of your benefits are tax free. With provisional income between $25,000 and $34,000, you’ll be taxed on up to 50% of your benefits. Above $34,000, you could be taxed on up to 85%.

Provisional income means your adjusted gross income (AGI), plus half of your Social Security benefits, plus any nontaxable interest income (such as interest on municipal bonds).

AGI equals the sum of your taxable income items reduced by the sum of your so-called above-the-line deductions for things like deductible contributions to a traditional IRA, self-employed retirement plan contributions, self-employed health insurance premiums, the deductible portion of self-employment tax, and alimony payments required by a pre-2019 divorce agreement.

The point is, at least 15% of your Social Security benefits will be federal-income-tax-free and maybe more, potentially up to 100%, depending on your provisional income.

Conclusion

While income and gains are usually taxable, this general rule does not always apply.

The fortunate truth is that you can collect federal-income-tax-free income and gains in several different ways, as illustrated in this letter.

So, please don’t assume that you owe taxes just because you will come out ahead in a transaction.

Instead, check with us before making significant moves. With advance planning, we can help you get the best tax results the law allows. After the fact, it may be too late to do that.

Very truly yours,

The Pinnacle CPA Advisory Group