How you deal with the new capital gains rates hinges on what your tax bracket is. The strategies to deal with cap gains differ for each level.
Capital gains taxes became very confusing last year. You might pay one of at least four different rates on market earnings, depending on how much income and gain you see in any year. Good news: You can take steps to 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 (the basis) is less than the proceeds you receive from the sale, you incur a capital gain.
The 0% rate. If you're in the 10% or 15% federal tax brackets (in 2014, you must make less than $73,800 annually if married filing jointly or $36,900 if you file tax returns as single), you have this capital gains rate available.
If in these brackets, you can realize capital gains between your current adjusted gross income(AGI) and the top of the 15% tax bracket each year at a 0% rate. If you let your gains build and realize them all in one year, you pay a 15% tax on much of the gain.
The 15% rate. Most middle-income taxpayers pay this. Sometimes, trying to avoid paying this rate is not worthwhile, as we'll show.
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. You owe federal tax of $1,500 (15%) plus your state tax. (In Virginia, where I live, that's an additional 5.75%, or $575, for a total tax of $2,075.)
That leaves you 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, meaning you need to earn a little more on whatever you reinvest in to make up for the loss from taxes. The extra amount that you have to earn to break even is the growth hurdle.
(We previously explored the amount of this hurdle based on the percentage of appreciation and the amount of time you hold the new investment.)
If your investment is highly appreciated and you can only increase the return or reduce theexpense ratio (operational costs that fund management charges you to oversee the money) by a little, say 0.20%, selling and buying slightly better investments may not pay. If you hold an investment with a higher-than-normal expense ratio (above 1%), selling the expensive position is nearly always better even if you must pay significant capital gains tax.
Another factor: If you hold highly appreciated stock in 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, work to trim your holdings in that stock.
The 18.8% rate. Should your modified adjusted gross income (MAGI) exceed $250,000 (if married filing jointly) or $200,000 (single), you owe an additional 3.8% for the Affordable Care Act. This tax rate applies up to the 39.6% federal bracket of $457,601 (if married filing jointly) or $457,601 (single).
In this situation, two financially successful persons have little incentive to get or remain married. The tax rates, and therefore the growth hurdle, are higher simply because their incomes or the profits of their businesses stack on each other and spill into the higher brackets.
Nevertheless, still diversify investments to reduce any one individual company's stock in your portfolio.
The 23.8% rate. If in the 39.6% federal tax bracket and making $457,601 (married filing jointlyor single), you are subject to a 20% capital gains tax. Since your MAGI is automatically high, you are also subject to the 3.8% Affordable Care Act tax as well, hiking your total federal tax to 23.8%.
Paying capital gains tax at this rate hurts, especially after adding in your top state tax rate. In Virginia that top rate is 5.75% – but California's 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 10 years you must earn 1.25% more in the new investment to achieve the same spending money in 10 years as with the old, inferior investment.
If you hold the investment until you die and your heirs get a step-up in cost basis, meaning the asset's cost basis resets to its current-day fair market value, your growth hurdle shoots to 2.24%
At this point, tap your charitable intentions. Gifting highly appreciated stock is one way to avoid such onerous tax rates.
David John Marotta, CFP, AIF, is president of Marotta Wealth Management of Charlottesville, Va., and is a member of the AdviceIQ Financial Advisors Network, which is a USA TODAY content partner offering financial news and commentary. Its content is produced independently of USA TODAY.