Tax Guy: 7 strategies for maximizing tax-free income

• Say you’re a married joint-filer with two dependent kids in 2022. You claim the $25,900 standard deduction. You could have up to $109,250 of adjusted gross income (AGI), including long-term gains and dividends, and still be within the 0% bracket. ($109,250 – $25,900 = $83,350 of taxable income, which is the top of the 0% bracket for joint filers in 2022.)
• Say you’re divorced with two dependent kids and file as a head of household. You claim the $19,400 standard deduction in 2022. You could have up to $75,200 of AGI, including long-term gains and dividends, and still be within the 0% bracket. ($75,200 – $19,400 = $55,800 of taxable income, which is the top of the 0% bracket for heads of households in 2022.)
• Say you’re unmarried with no kids. You claim the $12,950 standard deduction in 2022. You could have up to $54,625 of AGI, including long-term gains and dividends, and still be within the 0% bracket ($54,625 – $12,950 = $41,675 of taxable income, which is the top of the 0% bracket for single filers in 2022.)

AGI equals the sum of your taxable income items reduced by the sum of so-called above-the-line deductions for things like deductible contributions to a traditional IRA; up to $300 in cash contributions to IRS-approved charities if you don’t itemize or $600 if you’re a married joint-filer; self-employed retirement plan contributions, self-employed health insurance premiums; the deductible portion of self-employment tax; alimony payments made under a pre-2019 divorce agreement; up to $250 of educator qualified out-of-pocket expenses; plus up to another $250 if your spouse is also an educator who incurs qualified expenses and you file jointly.

If you itemize deductions, 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.

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Capital gains sheltered with capital losses are tax-free

When you incur capital losses during the year and/or have a capital loss carryover from a prior year, you can shelter current-year capital gains to the extent of current-year capital losses plus any capital loss carryover into that year. If you still have a net capital loss after this drill, you can use it to shelter 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 separate status.

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 yet reached age 18. A CESA is an account set up by a “responsible person,” which means you, to function exclusively as an education savings vehicle for the designated account beneficiary.

CESA earnings are allowed to 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.

Here’s the only catch: your right to make CESA contributions is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 or between $190,000 and $220,000 if you’re a married joint filer. This restriction can often be circumvented by enlisting someone who is unaffected. For example, you can give the contribution dollars to another trustworthy adult (maybe a sibling or parent) who can open up the CESA as the “responsible person” and make the contribution on behalf of your beneficiary. However, when the “responsible person” is someone other than yourself, you lose any control over the account. Keep that in mind.

Tax-free withdrawals from Section 529 college savings plans

Section 529 college savings plan accounts also allow earnings to accumulate free of any federal income tax. The big selling point is that 529 accounts allow folks who can afford to make bigger contributions to get their college savings programs off the ground in a hurry. Then when the account beneficiary (typically your child or grandchild) reaches college age, tax-free withdrawals can be taken to cover higher education expenses. State income tax breaks are often available too.

Contributions to a 529 account will also reduce your taxable estate (if you’re worried about that), because the contributions are treated as gifts to the account beneficiary. Contributions in 2022 are eligible for the $16,000 annual federal gift tax exclusion. Contributions up to that amount won’t diminish your unified federal gift and estate tax exemption. Assuming no tax-law change, the unified exemption for 2022 will be $12.06 million or effectively $24.12 million for a married couple. If you’re feeling more generous, you can make a larger lump-sum contribution and spread it over five years for gift tax purposes. That allows you to immediately benefit from five years’ worth of annual gift tax exclusions while jump starting the beneficiary’s college fund.

Example: If you’re unmarried, you can make a 2022 lump-sum contribution of up to $80,000 (5 x $16,000) to a Section 529 account set up for a child, grandchild or any other person you want to help. If you’re married, you and your spouse can together contribute up to $160,000 (2 x $80,000). Lump-sum contributions up to these amounts won’t diminish your $12.06 million unified federal gift and estate tax exemption. If you want to help several children or grandchildren, you can run the 529 account contribution drill for each one.

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 gain exclusion breaks. Assuming no tax-law change, QSBC shares issued after 9/27/10 will continue to be eligible for a juicy 100% gain exclusion, which equates for federal-income-tax-free treatment, if you hold the shares for over five years before selling. Consult your tax pro if you’re considering a small business stock investment that might be eligible for the QSBC gain exclusion deal.

Tax-free treatment for appreciated inherited capital gain assets

If you inherit a capital gain asset like stock shares or real property, the tax basis of the asset is stepped up to its full market value as of the date of your benefactor’s death or six months after that date if the estate’s executor so chooses. So, if you sell the inherited asset, you won’t owe any federal capital gains tax except on appreciation that occurs after the magic date. This super-taxpayer-friendly outcome is thanks to Section 1014(a) of our beloved Internal Revenue Code. The Biden tax plan included a proposal to greatly cut back the basis step-up break, but that idea appears to have been abandoned until further notice.

Tax-free Section 1031 real estate exchanges

Section 1031 of our beloved Internal Revenue Code allows you to postpone the federal income tax bill from unloading appreciated real property by arranging for a Section 1031 exchange, AKA a like-kind exchange. This time-honored maneuver is one big reason that some real estate investors have struck it rich over the years, because it keeps Uncle Sam out of their pockets. A proposal in the Biden tax plan would have severely limited your ability to postpone taxes with a Section 1031 exchange. But that tax-raising proposal is apparently off the table until further notice.

Here’s the big tax-saving bonus. If you pass away while still owning real property that you’ve acquired in a Section 1031 exchange, the tax basis of the property is stepped up as explained immediately above. So, your heirs can sell the inherited property and only owe federal capital gains tax on appreciation that occurs after the magic date, if any. Wow!

For details on Section 1031 exchanges, see my earlier column here.

The bottom line

While income and gains are generally taxable, you can collect federal-income-tax-free income and gains in a number of different ways, as I’ve explained in this column and its earlier companion. So don’t passively assume that you’ll owe taxes just because you came out ahead in a transaction. Check with your tax advisor before pulling the trigger on significant transactions, because sometimes, with good advance planning, you can get more tax-free money.