Hopefully 2020 has been kind enough to your clients to generate an oft-desired problem for them: big unrealized capital gains.
But those clients who want to take their profits on assets held in taxable accounts shouldn’t just blindly execute a sell order without first considering the consequences.
Here is how you can help your clients reduce their risk, realize the gains and still pay as little in taxes as possible.
Fearing the pain of the gains?
Often clients’ perceptions of the tax cost of realizing capital gains is much worse than the reality, especially on long-term gains.
In 2020, the federal tax rate applied to realized gains held less than 12 months (i.e., short term) is the same as the client’s income tax rate. For most taxpayers, that’s likely to be 35% or less, and for most retirees, it will be no worse than 24%. The federal long-term capital gains tax rate (applied to assets held at least 12 months) generally tops out at 20% and is usually 15% for all but the highest earners. For 2020, single clients with income below $40,000 pay 0% federal capital gains tax on long-term asset sales, as do married couples filing jointly with income below $80,000. Consequently the capital gains tax will usually be a very small portion of the overall sales proceeds, especially on long-term assets.
For instance, say a client has 1,000 shares of stock held longer than 12 months with a cost basis of $15 per share, and they are contemplating selling the position at $25 per share and paying a 15% tax on the $10,000 of profits. The gross proceeds from the sale would be $25,000, but the tax would be only $1,500—a mere 6% of the total proceeds. To provide even more motivation to the client to sell and pay the taxes, show them that in the above example if they don’t sell, the share price only has to fall to $23.50 before the overall value of the holding falls below what the after-tax proceeds would have been.
Split the sales
Since 2020 is quickly coming to a close, clients might want to identify what positions they want to sell and then sell only enough before the end of the year to keep them in the lowest possible tax bracket. Then after January 1, 2021, they can sell the remaining desired assets, splitting the gains (and taxes) between two tax years.
But keep in mind that the clients would still be incurring the potential risk (and reward) of the retained shares, along with the possibility of a change in the tax laws (and the clients’ tax situation) in 2021.
Take the bad with the good
Clients who have positions with unrealized losses held in taxable accounts should look to sell those positions, and use the realized losses to offset some or all of their realized capital gains.
Be careful which losing assets your clients sell—if the sale takes place within a 60-day window of the purchase of the asset (starting 30 days before the sale and ending 30 days afterward), the “wash sale” rule applies and the loss can’t be used for tax purposes.
This is an especially treacherous time of year for the “wash sale” issue, as many mutual funds are distributing dividends and capital gains, which may be automatically reinvested in the fund (i.e., making a purchase). Therefore, either take the client’s funds off of automatic reinvestment for the time being or plan on waiting at least 30 days after the last distributions are reinvested before selling any losing shares.
Give it away?
Instead of selling their potentially taxable appreciated assets, benevolent clients might want to donate the shares to a qualified charity. The process can be a little tedious, but not much more than selling the asset, calculating the cost basis, incurring capital gains taxes and then writing a check.
If the appreciated asset is worth more than what the clients would like to donate right now, they should look at placing all they wish to get rid of into a donor advised fund (DAF).
Then they will receive a larger tax deduction in 2020, and can choose if and when to donate from the DAF in the future (albeit, without a tax break at the time of the distribution). In an ideal scenario, the clients could donate some of their appreciated assets to the DAF in 2020 and then sell another portion in the same year. They could then use the tax break received by the donation to the DAF to offset all of the tax cost incurred by selling the appreciated assets.
Keep it in the family
Another way your clients can reduce the cost of capital gains tax is to “gift” the appreciated asset to another person (usually a child or grandchild).
If the gift is made while the donor is alive, the original cost of the asset transfers to the recipient and so will the capital gains if/when the recipient sells the shares. But if the recipient has low or no income, he is likely to pay little to nothing in capital gains tax upon the sale of the investment.
A couple notes of caution, however:
- If the recipient is a college student who will be applying for need-based financial aid, the sales proceeds may reduce the aid he would otherwise receive; and
- If the recipient is under the age of 24, the complex and onerous “kiddie tax” rules may increase the rate at which the capital gains are taxed and make the whole transfer moot.
Unintended consequences
Be cautious that realizing capital gains might trigger extra unwanted taxes that could have otherwise been avoided.
For instance, those gains may increase the likelihood that a client’s Social Security benefits are taxed or that a greater portion of the benefits will be subject to taxation. And realized capital gains may also cause clients with individual health insurance purchased under the Affordable Care Act to lose any low-income subsidies they are receiving.
Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).