Realize Some Capital Gains Each Year To Keep Taxes Low

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Monopoly Stock Sale

Capital gains taxes became very confusing last year. There are at least four different rates which you might pay depending on how much income and how much gain you have in any particular year.

0% Capital Gains Tax Rate

This capital gains rate is available for those in the 10% or 15% federal tax brackets (2014 under $73,800 married filing jointly or $36,900 filing single).

If you are in these tax brackets, you should be realizing capital gains between your current AGI and the top of the 15% tax bracket each year. Whatever gain fits under the top of the 15% bracket has a tax rate of 0%. Take advantage of this rate! If you let your gains build up and then realize it all in one year you will have to pay 15% tax on much of the gain simply because you failed to trim gains every year.

Case Study: John and Susan have a joint AGI of $53,800. They also have investments which have unrealized gains of about $50,000 after having appreciated for the past 5 years. Their investments are continuing to appreciate at about $10,000 a year.

John and Susan should have been realizing some gain each year. If they realized their entire $50,000 gain this year they would push their AGI to $103,800 and owe 15% on the $30,000 above the top of the bracket. They would owe an extra $4,500.

John and Susan should realize $20,000 in capital gains in their taxable account this year. This brings them to the top of the 15% federal tax bracket. No additional tax should be owed. Next year they will have $40,000 in unrealized capital gains. ($50,000 – $20,000 + $10,000 of growth for this year). It may take them five years, but they can gradually realize gains and still stay in the 0% capital gains tax bracket.

15% Capital Gains Tax Rate

This is the “normal” rate which most middle income tax payers must pay.

It is a mistake to avoid paying this tax rate simply to avoid paying it. It is also a mistake not to take capital gains into account.

When you sell $20,000 of  stock with a cost basis of $10,000 you have to pay capital gains tax on the $10,000 of gain. The federal tax owed would be $1,500 (15%) and the Virginia State tax would be an additional $575 (5.75%) for a total tax owed of $2,075.

That means you will only have $17,925 of your original $20,000 to reinvest. But when you reinvest, your new cost basis will start at $17,925 instead of $10,000. You will have to earn a little more on whatever you reinvest it in in order to make up for the loss on account of paying taxes.

We call the extra amount that you have to earn in order to break even the “growth hurdle.” We’ve written an another post entitled “Rules For Selling Highly Appreciated Stock” which explores the amount of this hurdle based on the percentage of appreciation and the amount of time the new investment is held.

Case Study: Mike and Cindy have $20,000 of stock with a cost basis of $10,000. If they sell this stock they will owe %15 federal capital gains tax and 5.75% Virginia State tax. (Note the addition of Virginia State tax changes the percentages of the hurdle tables.)

If the sell the $20,000 they will owe $2,075 and only have $17,925 remaining to invest.

Assuming that they could have earned 8% on their original investment and could earn 8.65% on their new investment, the payback period is 10 years. Put another way, the growth hurdle for an investment with a 100% appreciation where the money is not needed for at least 10 years is 0.65%.

On the other hand, if they would never need the money and could hold the original investment until they die and their heirs get a step-up in cost basis, the growth hurdle is 0.85%. The possibility of avoiding the capital gains tax for your heirs by continuing to hold the original investment raises the growth hurdle.

One of the applications to this tax math is that if you have an investment which is highly appreciated and you can only increase the return or reduce the expense ratio by a little bit (0.20%) it may not be worth selling and rebuying a slightly better investments. But if you have an investment with a higher than normal expense ratio (above 1.00%) it is nearly always better to sell the expensive position even if you have to pay significant capital gains taxes.

Another factor is that if you have highly appreciated stock in a single company, the risk to the portfolio is not worth trying to avoid capital gains tax. Whenever a single company’s stock represents over 15% of your total portfolio, you should always work toward trimming the stock back until it represents less than 15% of your portfolio.

Case Study: Steve and Cathy have $2 million of stock in a single company. Their entire portfolio is worth $5 million, so the individual stock represents about 40% of their total investable assets. Their taxable income (before any capital gains) is about $110,000, putting them in the middle of the 25% federal tax bracket and in the 15% capital gains tax rate.

Steve and Cathy should work to reduce the percent in a single company from 40% down below 15%. At the stock’s current value, that would mean they would only want a maximum of $750,000 in the single company. Therefore they should work to sell about $1.25 million of the company’s stock.

But if they sold all of the stock in a single year, they would owe more than 15% in federal capital gains.For any modified adjusted gross income (MAGI) over $250,000 they would owe an additional 3.8% Affordable Care Act capital gains tax for a total rate of 18.8%.

And for any amount that pushes them into the 39.6% federal tax bracket ($457,601 for married filing jointly), they would owe 20% federal tax instead of 15% for a total of 23.8% capital gains tax.

Steve and Cathy have a choice of diversifying their portfolio quickly (and expensively) or realizing some gain each year for a lower cost.

At a minimum they should realize at least the approximately $140,000 each year which can be kept within the 15% federal tax rate. Realizing capital gains at this rate it would still take Steve and Cathy 9 years in order to reduce their individual stock holding to $750,000 or 15% of their portfolio.

18.8% Capital Gains Rate

Anyone with a modified adjusted gross income (MAGI) over $250,000 (married filing jointly) or $200,000 (single) owes an additional 3.8%  for Affordable Care Act. This is the tax rate up until the 39.6% federal tax bracket of $457,601 (married filing jointly) or $457,601 (single).

This is one of the strange ranges where two highly successful people have a great disincentive to get or remain married. The tax rates and therefore the growth hurdle are higher simply because their incomes or the incomes of their businesses stack one upon another and push income into the higher brackets.

Never the less, it is still important to diversity investments such that any one individual company’s stock represents less than 15% of the portfolio. It is best to handle your investments such that you don’t generate a concentrated position in the first place. It is second best to pay the tax and diversify the position even if you have to do it gradually. The worst case is to remain highly concentrated in a single company’s stock just to avoid paying the tax.

23.8% Capital Gains Rate.

Anyone in the 39.6% federal tax bracket $457,601 (married filing jointly or single) is subject to a 20% capital gains tax. Since their MAGI is automatically high they are also subject to the 3.8% Affordable Care Act tax as well making their total federal tax 23.8%.

Paying capital gains tax at this rate is painful, especially after adding in the top state tax rate as well. In Virginia that top tax rate is 5.75%, but in California the top state tax rate is 13.3%. Hurdle rates become particularly important for decisions regarding realizing capital gains.

The 10 year growth hurdle in California for an investment with a 100% unrealized capital gain is 1.25%. That means even if you hold the new investment for ten years you would have to earn 1.25% more in the new investment to have the same spending money in 10 years as if you had just held the old inferior investment.

And if you are going to hold the investment until you die and your heirs will get a step up in cost basis, the growth hurdle is 2.24%

In cases like these it is helpful if the client has charitable intentions. Gifting highly appreciated stock is one method of avoiding such onerous tax rates.


Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.