How to Pay No Taxes on Your Dividends or Capital Gains
A Majority of American Households Can Now Pay No Federal Taxes on Common Stock
Due to past changes in the tax rules, dividend income and capital gains have become much more attractive as sources of passive income for investors who are in the lower and middle classes. Coupled with other intelligent portfolio allocation strategies, like taking advantage of free matching money in your 401(k) at work and fully funding a Roth IRA, these dividend tax changes mean you can now effectively drop your tax bill by a meaningful amount while enjoying streams of income that can show up as a check in the mail, a direct deposit into your bank or brokerage account, or a reinvestment back into the companies that paid them.
The tax benefits are so substantial, I'm genuinely surprised more people aren't talking about acquiring dividend stocks and dividend growth stocks to augment existing index fund holdings. In a very real sense, refusing to consider it means leaving potentially thousands upon thousands of dollars in free money on the table.
Dividend Tax Rules: The Basics
In tax year 2016, individuals who make less than $37,650 in taxable income, and married couples who make less than $75,300 in taxable income, now pay 0% taxes on qualified dividends and long-term capital gains. You read that right: 0%. Nothing. Not a single penny. This represents almost 4 out of 5 American households who can get away with avoiding dividend tax entirely at the Federal level; an astonishing fact that should be shouted from the rooftops. State taxes may still apply, depending upon where you live, but even in states with higher-than-average income, the Federal tax-free rate remains a huge benefit.
Going out and adding a new dollar in dividend income is now more advantageous to you on an after-tax basis than going out an earning an extra dollar of income from your labor, especially if you are self-employed and face higher effective taxes due to the double payment on the regressive payroll tax as you have to cover both the employer and employee portion.
Meanwhile, individuals earning taxable income of $37,650 to $190,150, and married couples earning a taxable income of $75,300 to $466,950, pay only 15% Federal taxes on their dividend income. However, the so-called Obamacare tax (or "Net Investment Income Tax"), which is not indexed to the inflation rate, is 3.8% on top of the 15% dividend tax. That portion only goes into effect for single people making $200,000 in income, for married people filing separately making $125,000 in income, and for married couples filing jointly making $250,000 in income.
Individuals earning more than $415,050 and married couples earning more than $466,950 will pay 20% in Federal dividend taxes plus the 3.8% Obamacare dividend tax for a combined rate of 23.8% to the IRS (again, depending upon where you live, state dividend taxes may apply, too).
Keep More of Your Passive Income by Taking Advantage of the 0% Dividend Tax Rate
If you are mathematically inclined, you may be seeing dollar signs as a result of already having worked out some of the ways to which you can use this favorable situation to your advantage. Individuals earning less than $37,650 and married couples earning less than $75,300 in taxable income could prioritize building up a long-term, diversified portfolio of directly held individual dividend growth and high dividend yield stocks.
On the opposite end of the spectrum, wealthy families who have adult children can go about lowering their estate taxes, taking advantage of the annual gift tax exclusion, and keep more investment income in the family through a fairly simple technique. Affluent parents can give their grown kids highly appreciated shares of dividend paying stocks, passing along the cost basis and unrealized gain so the deferred taxes aren't triggered. At the same time, the adult children aren't as likely to be earning outsized incomes like the parents, especially if they're just starting their own careers, meaning that unless they fall under one of the handful of child tax rules, the dividend income generated from the very same shares of stock are now tax-free at the Federal level. This can be huge, especially if combined with liquidity discounts in a family limited partnership (for more on that topic, read this article).
The major downside from a tax perspective is the loss of the eventual stepped up basis loophole.
An illustration might help. Imagine you live in New York and are in the top Federal tax bracket. Any dividends you collect are going to be taxed at 23.8% on the Federal level (20% for the base dividend tax and 3.8% for the Obamacare tax), plus be subject to a state tax of 8.8% and local tax of 3.9% as well. By the time all is said and done, you're going to give up 1/3rd of your dividend income to various tax authorities. Let's say you have a son who is launching a startup business in Dallas. He's married. While he isn't yet making any money at the startup, his husband or wife pulls in $50,000 a year as a teacher. That's well beneath the $75,300 tax-free dividend exemption level.
As long as this situation persists, you and your spouse can gift your son and his spouse dividend stocks each year, knowing that the dividends won't be taxed at all on the Federal or State level due to the lack of income tax in Texas. That means that almost 1/3rd of the dividends received on the shares you gave are now staying within your family instead of going to the government's pockets for politicians to spend. It also helps move money out of your estate, as previously mentioned, so that future appreciation on those shares won't be subject to the estate tax limits when you die.
Pay 0% in Capital Gains Taxes Using the Same Strategy
If we stick with the same scenario discussed above, an equally as intelligent strategy can be to have your son and his spouse sell the appreciated stocks you gifted since the capital gains in their bracket are tax-free, too. They can wait to get past the wash sale rule date and repurchase the investment. In effect, this lets you offload the capital gains tax to your kid, have them trigger the tax, and let them keep the money that would have gone to government. If the kid is fairly young - say, between 25 and 35 years old - the tax savings can be thousands upon thousands of dollars, which they can then keep on their personal balance sheet to compound for 30, 40, 50+ years. That one simple move might end up adding hundreds of thousands, or even millions, of dollars in future wealth to your family tree.
Utilize this strategy for multiple children and grandchildren and it might be possible you could save truly impressive amounts on your (and their) tax bill. It's one of those things that helps give some families an advantage over others; by transferring an asset from one pocket to another, and accelerating inheritances a bit earlier, you can let your heirs enjoy the fruits of your labor rather than members of Congress. It's a viable alternative to something like a charitable remainder trust, which can also provide major tax advantages.