The extended bull run in the U.S. stock market has put smiles on many investors faces. The popular S&P 500 stock index is up 101 percent since the start of 2010 while the NASDAQ stock index gained 144 percent over the same period. But when investors elect to sell, Federal and State taxes can take a substantial bite out investment returns, turning smiles to frowns. Investors need to be alert to actions they can take to keep capital gains taxes as low as possible.
Refresh my memory, how does the IRS define capital gains? When the value of an asset, such as an individual stock or mutual fund, is higher than what the investor paid for it, the difference is the capital gain. The gain is not realized until the asset is sold. When sold, the capital gain is classified as either short-term (meaning the asset was held for one year or less) or long-term (held for more than one year). The investor must include realized gains, netted against realized capital losses, in their income tax return and pay any associated capital gains taxes.
How will capital gains be taxed in 2017? Investors need to be aware of three different Federal taxes: short-term capital gains taxes, long-term capital gains taxes, and the Medicare contribution tax on net investment income. In addition, depending on where the investor lives, they may also be liable for additional state-based capital gains or income taxes.
Short-term capital gains are treated as ordinary income by the Federal government. So how much tax the investor pays will depend on how much ordinary income they report on their Federal income tax return. The short-term capital gains tax rate can be as low as zero percent and as high as 39.6 percent (see table).
Long-term capital gains generally fall into one of three tax brackets: 0%, 15%, and 20%, which for most investors is less than the tax they would pay on ordinary income. Because of the preferential treatment of long-term capital gains, investors should make every effort to hold an investment for more than one year (at least one year plus a day) so they can enjoy this important tax benefit. Whether they pay 0%, 15%, or 20% depends on how much ordinary income they earn in the year in which they realize the long-term capital gains (see table).
In addition to Federal short-term and long-term capital gains taxes, investors with incomes above a threshold must also pay the Net Investment Income Tax, which went into effect on Jan. 1, 2013 as part of the Affordable Care Act. High-income taxpayers are subject to a 3.8% Medicare contribution tax on net investment income, which includes gains from the sale of stocks, bonds, and mutual funds. For example, married couples filing jointly with more than $250,000 of ordinary income, must pay this additional tax on realized capital gains. Suppose this couple also had $10,000 of realized long-term capital gains. Referencing the tables above, the couple would be in the 33% tax bracket for purposes of ordinary income and 18.8% for long-term capital gains (the 15% capital gains tax rate plus the 3.8% net investment income tax rate).
But the capital gains tax bill may not stop there, depending on where the investor lives. If a New York State resident, they could be liable for an additional 8.8 percent capital gains tax because capital gains are treated as ordinary income. It is also important to remember that unlike wages, federal and state taxes are not automatically withheld from capital gains proceeds. If an investor has significant realized gains, then they should consult with their financial and tax advisors to make estimated tax payments, so they do not incur IRS penalties.
What strategies can investors follow to minimize capital gains taxes? There are 5 strategies that investors should be aware of, from simple techniques to those that require more planning.
1. Wait at least a year and a day. For capital gains to qualify for long-term status and a lower tax rate, wait at least a year and a day before selling an investment. The tax rate the investor will pay on the gain will be between 10 and 20 percentage points lower than the short-term capital gains tax rate, depending on the amount of ordinary income they earn.
2. Time capital gains with capital losses. The IRS permits taxpayers to offset realized capital gains with realized capital losses. For example, if an investor realized $40,000 of long-term capital gains but also realized $25,000 capital losses, then for tax purposes, their net gain is only $15,000.
3. Sell when your income is low. Taxpayers in the 10% and 15% income tax brackets escape having to pay long-term capital gains taxes. If an investor’s income is particularly low one year, that may be a great time to realize some long-term gains. For example, based on the tables above, a married couple with ordinary income of $60,000 is in the 15% income tax bracket, but the 0% long-term capital gains tax bracket.
4. Consider gifting appreciated assets to children. The IRS permits taxpayers to gift up to $14,000 per year, without incurring any gift taxes. If the person receiving the gift is in a lower income tax bracket than the gifter and elects to sell the investment, then they will be able to pay lower capital gains taxes. For example, suppose a married couple each gift $12,000 of securities to their 10-year-old child, with each gift having $6,000 of embedded long-term capital gains. The total value of the gift is $24,000, with $12,000 of it characterized as long-term capital gains. Because the gift is below the threshold level, the parents do not have to pay any gift taxes. Moreover, because the child is likely in the 10% or 15% income tax bracket, they will likely incur no capital gains tax when the securities are sold. But if their parents had sold the securities rather than gifting them, they would have been liable for capital gains taxes.
5. Consider holding appreciated assets so an investor’s heirs benefit from a step-up in basis. Tax laws are notoriously complex. But there is an important wrinkle associated with estate taxes that creates an important tax planning tool to minimize capital gains taxes. When someone dies, the IRS permits assets owned by the deceased to pass to their heirs at the then current market value, without being liable for any capital gains taxes. The original cost basis gets wiped out entirely. For example, suppose many years ago, an investor purchased $100,000 of an S&P 500 index fund that is now worth $300,000. If she elected to sell the index fund during her lifetime, the $200,000 of gain would be subject to capital gains taxes. But if instead the investor held the index fund until she passed away, it would pass to her heirs at $300,000, with no capital gains being due on the transfer. This step-up in basis is a huge advantage that can dramatically influence decisions on when to sell appreciated securities.
NOTE: Nothing in this post should be considered as rendering legal or tax advice for specific cases. Readers should be sure to discuss their specific circumstances with their financial and tax advisors before taking any action.
DISCLAIMER: This information is not intended to provide legal or accounting advice, or to address specific situations. Please consult with your legal or tax advisor to supplement and verify what you learn here. This is presented for informational or educational purposes only and does not constitute a recommendation to buy/sell any security investment or other product, nor is this an offer or a solicitation of an offer to buy/sell any security investment or other product. Any opinion or estimate constitutes that of the writer only, and is subject to change without notice. The above may contain information obtained from sources believed to be reliable. No guarantees are made about the accuracy or completeness of information provided. Past performance is no guarantee of future results.