Is what I'm doing to avoid paying taxes legal?

[moneydummy]

Hi fellow frugal friends,

I have found myself in a particularly special financial situation and I want to make sure it isn't too good to be true (usually I find that most good-looking things are as such).

I am a young professional making a reasonable amount of money.  I have access to a 401k plan at work, which I have been aggressively saving in for years  (part of the reason for this is that I am able to reduce my taxable income AND tax bracket and as such pay lower taxes to lock in a low tax rate to make Roth IRA contributions).  So, long story short, I've been manipulating my tax rate to lower my effective rate and keep my top marginal rate to keep taxes low for my Roth IRA contributions (e.g. 15%).

Here's the twist.  A few years ago, I was granted some stock options at a company I used to work for.  The strike price was super duper low, so as soon as the company went public, I bought up my shares for very little cost and sat on them.  The one year holding period to make this into a long-term investment is rapidly approaching, and I was in the magical middle-zone for this investment so I am not subject to AMT.  Since my purchase, the shares have increased in value a lot (not retire-at-27 a lot, but it's a bunch of money for sure).

I know that long-term capital gains tax rates are 0% for people in the 15% tax bracket.  Does this mean that, by doing what I was already doing (plowing money into my 401k in order to manipulate my tax rate to 15%), I do not have to pay federal income tax on my very large long-term investment return?  I see nothing in the tax code that prevents this, nor do I see any ceiling on the amount of money I can theoretically do this with (it could be millions of dollars for Pete's sake!).

Can someone confirm this for me?  If it's true, I will be very happy for sure.

Thanks guys!

[moneydummy]

PS: Of course, I know I will have to pay state tax.  I'm just talking about federal income tax here.  Thanks!

[Catbert]

The free capital gains is only to fill up your 15% bracket, NOT all of it.  So if your taxable income (ignoring the capital gains) is 5K below the top of your 15% bracket only the first 5K in capital gains is at 0%.  In that example if you have 10K of capital gains 5K is taxed at 0% and 5K at 15% cap gains rate.

[gimp]

Mary is correct. As long as your total adjusted gross income is in the 15% or less bracket, you pay no income tax on the long term capital gains. Long term capital gains are part of your total adjusted gross income.

So: salary + capital gains - deductions including 401k = total AGI, to slightly oversimplify. If that puts you in 15%, no tax on the gains.

[moneydummy]

Interesting, thanks Mary and gimp.  Can you guys point me to the IRS rule that lays this out for me?  I must have missed this.  Thanks!

[seattlecyclone]

Try this link. It has a table that lays out the rate you'll pay for a capital gain and it depends on what the "regular tax rate that would apply" to the gain would be if capital gains were taxed at the same rate as ordinary income. So you get free capital gains to the extent that your gains put your total income up to the top of the 15% bracket, 15% capital gains tax up to the top of the 35% bracket, and 20% capital gains tax in the 39.6% bracket.

This rule is also embodied in the worksheet you use to calculate your tax when you have capital gains income. Note that Line 11 on that worksheet is an amount that is taxed at 0%, but this amount is limited by the top of the 15% bracket. Then after that you calculate the amount of capital gains income that is subject to the 15% rate.

So if you're close to the top of the 15% bracket already, you'll pay 0% tax on part of your gain, but it's likely that you'll pay 15% on most of the gain. You might want to spread your stock sale across a couple of years to take advantage of as much 0% tax as possible. Only do this if you're fairly confident the company will be around when you sell your last share though; better to get a good price today and pay tax on it than sell for less later but pay no tax.

[dragoncar]

Can I assume you paid taxes when you executed your options?

[moneydummy]

Thanks seattlecyclone, that is helpful.

dragoncar, I did not; I did not generate a taxable event as I did not sell any shares, only bought, and I was not subject to AMT.

[moneydummy]

Alright!  I've learned something new today.  And it's a good thing too... I would have been on the way to a rude awakening in my near future.  Thanks guys, I really appreciate your input.  Of course, if anyone has anything else to add, please do!  :)

[gimp]

Buying stock on a discount is often (usually? always?) a taxable event. Look into this and double-check it.

[wild wendella]

ditto that.  when I bought ISOs (Incentive Stock Options - is that what yours are?) I had to pay tax on the difference between what the stock was worth when I purchased it, and the amount I purchased it for.  This was ordinary income tax.  This lead to me having to sell some that year to a) lower that tax, and b) pay that tax.  Also, with ISOs I think to get the long long term cap gain you have to hold two years, though I may be misremembering.  In my case, the stock price went down after I purchased, and the entire deal stunk.  Additionally, my accountant didn't seem to know as much about ISOs as an accountant should, and the state came after me for filing wrong.  In retrospect, I should have done the filing myself.  Anyway.. there's a ton of info online if yours are Incentive Stock Options.  If not, then ignore this entire post.

[seattlecyclone]

If the OP got the stock through exercising an Incentive Stock Option, it is not a taxable event for the purpose of the "regular" federal income tax, provided that the holding period requirements (two years from option grant date and one year from option exercise date) are met.

It is a taxable event for the AMT, which leads to all sorts of fun tracking different cost basis for the two tax types. The OP already mentioned the AMT, so I'll assume any potential AMT liability has already been considered and that the amount of extra AMT income was not high enough to actually trigger AMT in this case.

[seattlecyclone]

ditto that.  when I bought ISOs (Incentive Stock Options - is that what yours are?) I had to pay tax on the difference between what the stock was worth when I purchased it, and the amount I purchased it for.  This was ordinary income tax.

This amount is only considered income for the ordinary income tax if you sell the shares before the holding period is met. Otherwise it only counts as income for the AMT. See this IRS publication for more details.

[wild wendella]

Ah right, the AMT tax.  It was a long time ago.  I'd blocked it out... 

[Joel]

I wanted to add when you are straddling the 15% and 25% marginal tax brackets, you can actually be in a position where your actual marginal tax rate is 30%. For example, 1 additional ordinary income dollar is taxed at 15% which causes an additional qualified dividend or long term capital gain to also be taxed at 15%. It's something I am very aware of in trying to avoid the 25%+ marginal tax bracket myself.