What To Do About Your Capital Gains - Part 3

You’ve made it to part 3 of our series on capital gains! If you’re unfamiliar with the concept of capital gains please take a moment to review part 1 where I go over the basics. Part 2 discusses some ways to handle capital gains based on your income situation, other investments you may own, and charitable intentions.

Part 3: Beware of sneaky additional taxes and potential tax traps from your capital gains

Just about everything that lands on one line of your tax forms usually comes into play on other lines as well. Capital gains are fun, but too much of a good thing has the potential to trigger additional taxes or eliminate other benefits provided in the tax code. Let’s take a moment to review these before you hit that “sell” button. ‍

Watch out for the net investment income tax:

The additional tax on net investment income of 3.8% went into effect on January 1st, 2013. If your modified adjusted gross income is above the thresholds below then all or part of your investment income, which includes capital gains, may be subject to the additional 3.8% net investment income tax.

Source: IRS

How to use this information

It is important to work with your accountant and your financial planner if this situation might affect you. While in some cases paying the surtax may be unavoidable, for some people with income that fluctuates from year to year selling stock in a lower income year may make sense. For others close to the thresholds, recognizing gains piece by piece over multiple years can keep you from stepping over the income limits.

However as I discussed previously, this is a perfect example where the decisions can not be made solely on the tax situation. Sometimes an investment just has to go, and if your expectation is that the stock will be down 50% a year from now, better to pay 3.8% to be rid of the position and keep the gain you have then lose half your investment.‍

Resist the urge to gift highly appreciated stock to family

‍In part 2, we discussed the awesome benefits of gifting a highly appreciated stock. You avoid the capital gains and the charity receives the full value of the stock. Unfortunately, gifting stock during your lifetime to another person does not carry the same kinds of benefits.

How to use this information

When you gift appreciated stock to another person, that person also gets the gift of your cost basis for tax purposes. If you gift your

You gift your tax liability along with the stock you gift to family. child the Zoom stock you paid $67 for and now trades at $382 per share, the recipient of the gift would owe the full amount of capital gains if the stock was then sold.

This is a big issue when an elderly parent gifts stock to one of their children who are in prime working years, and high income brackets. The tax-wise thing to do would have been to hold on to the stock until it could be inherited by the child as a beneficiary. In that case the cost basis is stepped up. In other words the beneficiary’s cost basis is increased to the value of the stock on the date of the original holder’s death, the capital gains tax liability is eliminated, and a great tax benefit is realized.

The one situation where this could work favorably is when the owner of the stock is in a high income tax bracket and gifts the stock to someone in a considerably lower bracket. Say a high level worker in their 50’s at the peak of their career gifts stock to their 24 year old child fresh out of college to sell for a down payment on a new home. This could allow the stock to be taxed at a lower rate if the math works out.

Gifting to your dependent children won’t get you far though, as the kiddie tax will quickly step in to erase any tax benefit. ‍

Be aware of the affect capital gains have on your income in general and various income thresholds‍

Taxes are complicated, and what happens on one line of your 1040 rarely stays on just one line if your 1040. Again this is where working with your accountant and financial planner are critical, as selling too much stock could jeopardize other tax benefits or deductions available to you.

How to use this information‍

For example, you have always been told that making a Roth IRA contribution every year is a great way to save. Since a Roth IRA is a tax advantaged account, the IRS places limits on who can contribute. For 2021, a single tax filer with a Modified Adjusted Gross Income (MAGI) above $140,000 can not make a Roth IRA contribution.

Now let’s say you are a single taxpayer with income of $120,000 after deductions for things like 401k contributions. In addition, you also have a $25,000 long term gain from some technology stock you have been holding on to for a couple years and a lucky investment in the vaccine maker Moderna (MRNA) in early 2020 that has paid off handsomely. If you sold your stock all at once and recognized all $25,000 in capital gains in the same year you will have increased your income to $145,000, beyond the threshold set by the IRS, phasing you out of the opportunity to make a Roth IRA contribution. Careful planning by an accountant or financial planner may have suggested selling the stock over multiple years, keeping income below key IRS thresholds.

Taxes are complicated. If you are sitting on capital gains from 2020, or from any year for that matter, consider when the right time to sell is and the various strategies to mitigate the bite of the capital gains tax bill. Better yet, consult with a professional that can analyze your situation from multiple angles to help you make the best decisions with your investment earnings.