The following is a guest post from Marotta Wealth Management. I have made my share of tax mistakes when selling assets, but have also used market downturns (like 2008) and charitable donations of stock (as he notes below) to strategically readjust my holdings. I should be in a place where I don't need to sell any assets for quite some time, but this is a topic that we all still need to be reminded of and consider from time to time. Not sure his "capital gains should be 0%" at the end is right, but it would make things much simpler.
How you deal with the new capital gains rates hinges on your tax bracket. The strategies to deal with capital gains differ for each level.
Capital gains taxes became very confusing last year. Before 2013, there were only two capital gains rates for assets held for more than a year. Now you may pay one of at least four different rates on market earnings, depending on how much income and gain you see in any year. But through strategic planning, you can chip away at even the harshest tax rates.
When you sell certain assets, such as stocks and bonds, you may incur capital gains. A capital asset also includes most property you own and use for personal or investment purposes. If the original purchase price of the asset plus associated expenses (collectively called the "cost basis") is less than the proceeds you receive from the sale, you incur a capital gain.
If you’re in the 10% or 15% federal income tax bracket, you are eligible for the 0% capital gains rate. You can realize capital gains equal to the difference between the top of the 15% income tax bracket and your current adjusted gross income without incurring additional tax. However, if you realize too many gains all in one year, you must pay a 15% tax on the amount.
In 2014, remaining in the 0% rate means keeping the sum of income and capital gains below $73,800 annually for married filing jointly and below $36,900 for single filing.
Most middle-income taxpayers pay the 15% rate. Trying to avoid paying this rate is not always worthwhile.
For example, when you sell $20,000 of stock with a cost basis (original value) of $10,000, you pay capital gains on the $10,000 of gain. If you are in the 15% bracket, you owe federal tax of $1,500 plus your state tax.
If you made the sale to rebalance your portfolio, this tax leaves you with only $17,925 of your original $20,000 to reinvest. When you reinvest, your new cost basis starts at $17,925 instead of $10,000. Since you have less to reinvest and earn a return, you need to earn a little more to make up for the loss from taxes. The extra amount you have to earn to break even is called the "growth hurdle." The size of the hurdle can be calculated using the percentage of appreciation and the amount of time you hold the new investment.
Any new investment you choose will need to overcome the hurdle. It can sometimes be accomplished by purchasing an investment with a lower expense ratio than the one you sold.
If you hold highly appreciated stock of a single company, the risk to your portfolio is not worth trying to avoid capital gains. Whenever a single company’s stock represents more than 15% of your portfolio, use a tax savvy strategy to trim your holdings in that stock bit by bit each year.
Should your modified adjusted gross income (MAGI) exceed $250,000 (for married filing jointly) or $200,000 (for single filing), you owe an additional 3.8% beyond the tax rate of 15% thanks to the Affordable Care Act (ACA). This created the new rate of 18.8%.
This tax rate always applies to the 35% federal bracket, those earning under $457,601 (if married filing jointly) or $406,751 (single) annually. This surtax may also apply to the brackets below it. MAGI can be significantly larger than taxable income because it is not reduced by "below-the-line deductions."
The same surtax will also always apply to the topmost bracket as well. In the 39.6% federal tax bracket and making over $457,601 (married filing jointly) or $406,751 (single), you are subject to a 20% capital gains tax. Since your MAGI is automatically high, you are also subject to the 3.8% ACA tax, hiking your total capital gains tax to 23.8%.
Because of the ACA surtax, two financially successful people have little incentive to marry or remain married. A cohabiting couple each earning $200,000 can avoid the 3.8% surtax, whereas their married counterparts will face the full 18.8% rate in addition to other federal income tax penalties.
The tax rates, and therefore the growth hurdle, are higher for married couples simply because their incomes or the business profits stack on each other, pushing them into a higher bracket.
Some hurdle rates are so high, it is not worth selling well-performing appreciated investments. However, two options other than selling are available.
First, if you are charitably inclined, you can use your highly appreciated stock as gifts to the charities you support. You get the full deduction of the donation. The charity, as a nonprofit, does not have to pay the capital gains when it is sold.
Second, if you are charitable to your family, you can gift highly appreciated stock to family members who might be in a lower capital gains tax bracket. Children do not get a step up in cost basis, but selling the investment in their lower bracket may mean retaining more of the value.
Each donor can gift up to $14,000 per year per recipient without paying gift tax.
Thus a couple could gift $28,000 of highly appreciated stock to each of their children. If the sum of $28,000 and the child's income was below $36,900, the child would pay no capital gains tax. For a married child, you could gift $56,000, each spouse gifting the maximum to each spouse. If the sum was below $73,800, the child's family would pay no capital gains tax.
That all being said, the tax code leaves persons who are not charitably inclined or need the investment's value without a clear way to retain the value of their investments when rebalancing their portfolio or liquidating a part of their wealth.
Paying capital gains tax at rates of 18.8% and 23.8% hurts, especially after adding in your top state tax rate. In Virginia that top rate is 5.75%, but elsewhere it is much higher (e.g., California at 13.3%). Hurdle rates become particularly important for decisions regarding realizing capital gains.
Careless transactions in large portfolios can have huge tax consequences. It shouldn't be only those with a savvy financial advisor who are able to dodge this tax bullet. It would be far preferable if we had a capital gains rate of 0% for everyone.