A reader recently asked me about the zero capital gains tax rate and how it applies to deciding whether to pay off your mortgage. I wrote about this decision in multiple posts that began with Investing the Mortgage.
Retirees can have a broad range of tax situations, so I excluded taxes from those analyses. To adapt the analysis to your own financial situation, you should include tax considerations. You can do that by using your own after-tax mortgage cost, but you also have to use your after-tax expected portfolio returns.
In other words, you will be subtracting a lower mortgage payment from a lower expected portfolio rate of return to determine your expected after-tax return for the mortgage-to-invest strategy. The risk (variance) of this strategy, however, remains the same as that of your stock and bond portfolio, just as it did with the before-tax analysis.
The zero capital gains tax part of his question, however, deserves some discussion. Here are some important points.
I often read in the financial press that taxpayers will pay no capital gains taxes if taxable income does not exceed the upper limit of the 15% tax bracket, which will be $73,800 in 2014 for joint returns and $36,900 for single returns. While this is correct, it omits the fact that those capital gains will be added to your taxable income, possibly pushing some or all of your gains out of the zero capital gains tax bracket.
The maximum amount of capital gains that will go untaxed depends on the amount of your taxable income before the capital gains are added. The net effect is that tax-free gains are limited to the upper 15% tax bracket amount ($73,800 for joint returns in 2014) less your other taxable income.
Let's look at how the tax is calculated. Adjusted Gross Income (AGI) includes salary, taxable interest, ordinary dividends, traditional IRA distributions, income from pensions and annuities, and capital gains. From AGI, we subtract exemptions and deductions to arrive at taxable income. This is the figure we take to the tax tables to calculate how much tax we owe.
Let's say that Joe has $93,800 of combined annuity income, traditional IRA distributions, interest, and dividends and $20,000 of exemptions and deductions. His taxable income before selling stocks will be $73,800. Should Joe sell stocks with a long term capital gain of $10,000, all of the gain will be taxed at 15%, not zero. That's because his other $73,800 of taxable income has already pushed him out of the zero percent tax bracket before the capital gains are added.
Now, let's assume that Joe has just $20,000 of adjusted gross income but still has $20,000 of exemptions and deductions. His taxable income is zero. Now, if he sells stocks with a long term capital gain of $10,000, he will pay no capital gains tax on that sale. In fact, he could sell stocks with gains up to $73,800 and still pay no capital gains tax.
Any sum of "other taxable income" and capital gains exceeding $73,800 will have no capital gains tax due for the first $73,800, but the excess will be taxed at 15%.
Also, keep in mind that the zero capital gains tax bracket applies to Federal taxes. You may also be subject to state taxes and many (perhaps most) states tax capital gains the same as ordinary income. No break there.
Retirees receiving Social Security benefits should also be aware that increasing AGI by selling capital assets for a gain might trigger or increase taxes on Social Security benefits. You may pay no Federal capital gains tax on the stock sale only to see your Social Security taxes increase.
Of course, any withdrawals from a traditional IRA are taxed as ordinary income and don't receive capital gains preference, anyway. If you would pay the mortgage from those IRA investments, the zero capital gains tax would be irrelevant to the decision.
It's a fairly complicated tax issue and I recommend you discuss it with a tax pro before you sell. That's what I do.
Mostly, I recommend that you not simply assume that you won't have to pay capital gains taxes after you retire. Even if you have room to squeeze some tax-free gains under the 15% income tax bracket limit, other Federal taxes, like Social Security taxes, or state income taxes might come back to bite you in the butt.
Best to check with your tax guy before you sell and to keep this in mind when developing your retirement plan.