No Tax on Investment Gains?
By Kevin Estes
Selling for a gain might have no tax impact
According to the Internal Revenue Service (IRS), no tax is due on long term gains for the year if taxable income is:
less than or equal to $89,250 for married filing jointly or
less than or equal to $44,625 for a single taxpayer.*
Those capital gains are taxed at a 0% tax rate!
It may make sense for taxpayers with taxable income less than those thresholds to sell assets which have rising in value.
Selling those assets later when the couple or individual has more income could generate a 15%, 20%, or even higher taxes.
The challenge is knowing the definition of terms like:
capital gain,
long term,
and taxable income.
Capital gain
For the sale of an asset to have a capital gain, it must be:
a capital asset and
sold for a gain.
Almost everything you own and use for personal or investment purposes is a capital asset. Examples include a home, personal-use items like household furnishings, and stocks or bonds held as investments.
Great. Most of what we own is a capital asset.
What’s a gain?
That answer also comes from the IRS:
You have a capital gain if you sell the asset for more than your adjusted basis.
Unfortunately, the definition hinges on yet another IRS term.
Adjusted basis is normally what it cost someone to buy the asset.
Let’s say someone purchase share of stock for $100. However, they bought it 20 years ago and paid a $5 commission to purchase it.
Their adjusted basis is the $100 they paid for it plus the $5 commission.
Let’s say they sell the stock for $150. Their capital gain is $45:
$150 sale price - $105 basis = $45
Long term
How does the IRS define long term?
After all, 20 years seems like a long time. So does 3 years.
An investment which goes poorly can feel like it’s been owned a long time after only a few days!
The IRS defines long term as over a year. That means a year and a day.
If someone bought an investment on 12/11/2022, the gain or loss would generally be:
short term if it’s sold on 12/11/2023 or earlier and
long term if it’s sold on 12/12/2023 or later.
Why does it matter?
Short-term capital gains are taxed at higher rates than long-term capital gains. Short-term capital gains are usually taxed at someone’s (higher) marginal tax rate.
Taxable income
The definition of taxable income is what’s on the tax return.
Taxable income includes income from almost everything - wages, salaries, bonuses, business profits, investment income...
Fortunately, taxable income is also lowered by some contributions and deductions. For instance, it’s reduced by contributions to:
retirement plans like 401(k), 403(b), 457(b), and traditional Individual Retirement Arrangements (IRAs) as well as
cafeteria plans like Health Savings Accounts (HSAs) and dependent care Flexible Spending Accounts (FSAs).
Taxable income also excludes the standard or itemized deduction.
Itemized Deduction
Itemized deductions are expenses which are allowed to lower taxable income like:
state and local taxes,
home mortgage interest, and
charitable contributions.
There are limits to how much can be deducted on the tax return for these and other expenses.
Standard Deduction
The standard deduction reduces taxable income for everyone without higher itemized deductions. It allows people to earn a bit without being taxed, which is especially helpful for those with little income.
For 2023, the standard deductions are:
$27,700 for married couples filing jointly and
$13,850 for single filers.
The standard deduction makes it possible for taxpayers to pay $0 in capital gains taxes with total income of:
$116,950 for married filing jointly ($89,250 + $27,700)
$58,475 for single filers ($44,625 + $13,850).
It may be even higher with more itemized deductions.
Capital gains and related taxes
Capital gains tax
There are three capital gains tax rates based on taxable income:
0%
15%
20%
The taxable income ranges for the 15% level are broad. For 2023, they’re:
$89,251 to $553,850 for married filing jointly and
$44,625 to $492,300 for single filers.
Above that, the 20% rate applies. Below that, the 0% rate applies. It’s common to pay a 15% capital gains tax rate.
Why does the U.S. government have a different tax rate for capital gains than it does for ordinary income?
It’s to encourage people to invest!
Net Investment Income Tax (NIIT)
There is another major tax which applies to investment - the Net Investment Income Tax, or NIIT.
This is an additional tax on investment income for higher earners.
The Net Investment Income Tax is 3.8% on the lesser of:
the net investment income, or
the excess of modified adjusted income over the following threshold amounts
$250,000 for married filing jointly
$200,000 for single filers.
Underpayment tax penalty
Something else which may apply to capital gains is the underpayment tax penalty.
It’s best practice to pay quarterly estimated payments on the sale of appreciated assets. If someone doesn’t pay enough throughout the year, they could be charge a penalty!
The penalty can generally be avoided if:
they owe less than $1,000 on their tax return, or
they paid at least 90% of the tax shown for the taxable year or 100% of the tax return on their previous year, whichever is lower
It depends on the situation
Whether it makes sense to sell an investment for a gain and potentially pay capital gains taxes depends on many factors, including:
diversification,
current taxes,
future lifetime taxes, and
taxes after death
Diversification
It’s not uncommon for someone to have a significant amount of employer stock due to compensation like:
Restricted Stock Units (RSUs),
Employee Stock Purchase Plans (ESPPs), and/or
Incentive Stock Options (ISOs).
Single stock exposure is a significant risk. Look at what happened to Enron, Arthur Andersen, and many other companies!
Don’t let the tax tail wag the investment dog. It’s important to diversify - especially considering the lower capital gains tax rate.
No-one wants to pay lower taxes because they waited too long and the value fell!
Current taxes
Someone’s current tax situation may impact the timing of a sale. Below are just a few considerations.
Healthcare exchange subsidy
Subsidies for healthcare exchange insurance premiums are based on income. Selling appreciated assets could drive up income and reduce someone’s subsidy.
Net Investment Income Tax (NIIT)
If someone is currently subject to the 3.8% additional tax, it may make sense to delay selling an appreciated asset. The opposite is true if they’re not currently subject to NIIT yet may be in the future.
State income tax
Each state taxes income differently. Some states like Washington and Texas don’t charge income taxes! Other states like California and Oregon charge relatively high income taxes.
If someone who lives in a state without an income tax is considering moving to a state with an income tax, it may make sense to sell appreciated assets before moving.
Charitable giving
If someone owns assets which have gone up in value and regularly donates to charity, it may not make sense to donate cash!
Nonprofit organizations do not pay taxes. If someone were to donate appreciated assets instead of cash:
the donor may receive a tax deduction for the full value,
the charitable organization could use the entire amount, and
the donor could avoid paying capital gains tax.
Selling appreciated stock to give cash could reduce how much the charity receives!
There are limits to how much can be deducted each year for charitable giving. Those limits are based on income and generally lower for donations of appreciated assets than for cash.
Also, a taxpayer typically needs to itemize their deductions to receive a tax benefit. If the standard deduction would otherwise save more taxes, initial donations may not result in any tax savings.
Alternative Minimum Tax (AMT)
There’s a separate, parallel tax system most never notice. It helps ensure higher income individuals do not avoid too much tax in certain situations. One of the most common ways the Alternative Minimum Tax (AMT) comes into play is with Incentive Stock Options (ISOs).
AMT impact is usually temporary. An extra tax one year will generally save tax sometime in the future.
Nonetheless, it may make sense to sell appreciated assets in a year subject to the Alternative Minimum Tax. Doing so might increase income for the year without increasing the tax expense - a win!
Sequence of returns risk
A major risk to retirement is sequence of returns risk.
Returns and inflation are volatile. The worst situation for a recent retiree is stagflation:
a falling (or stagnant) market plus
high inflation.
A retiree in that situation would have to pay substantially more for goods and services… with a smaller portfolio! They may be forced to sell depressed assets, putting pressure on their financial plan.
Taxes are one expense which might be delayed. Someone can hold off on selling appreciated assets.
Paying less in tax could reduce taxes in the critical first few years of retirement. That lower expense could help a portfolio absorb the impact of short-term inflation and/or recession.
Future lifetime taxes
As important as someone’s current tax situation is what will happen in the future.
Future income
Someone who expects to earn significantly less later may pay a lower capital gains rate than they would now. That income might also avoid NIIT.
All else equal, it may make sense to delay that income by holding the assets until later.
Required Minimum Distributions (RMDs)
Someone with balances in traditional retirement accounts like 401(k), 403(b), 457(b), and Individual Retirement Arrangements (IRAs) may be forced to withdraw funds annually - even if they’d prefer to keep the assets in the account!
These accounts defer income. Uncle Sam essentially gets impatient and demands some of that deferred income get taxed now.
The SECURE 2.0 Act raised the age someone must begin taking RMDs to age 73 for 2023.
How much someone must withdraw as taxable income depends on their age. The older they are, the higher the percentage they must withdraw!
Required Minimum Distributions are literally based on someone’s age and average life expectancy:
Amount to withdraw = account balance / life expectancy
Each taxpayer’s life expectancy falls by about 1 each year, increasing the percentage they must withdraw each year.
Required Minimum Distributions on large portfolios could result in high future income. It may make sense to sell highly appreciated assets before RMDs start.
Fortunately, Required Minimum Distributions do not apply to Roth or Health Savings Accounts.
Donor Advised Fund (DAF)
If someone with appreciated assets is charitably inclined, they might consider a Donor Advised Fund (DAF).
A DAF provides a way to make a charitable contribution now and determine which nonprofits receive a donation, how much they receive, and when they receive it later.
Some benefits of a Donor Advised Fund include:
results in a tax deduction in the year made,
allows the donor more flexibility, and
facilitates the use of funds for smaller nonprofits which may not have the resources to handle appreciated assets.
Better yet, donating appreciated assets into a Donor Advised Fund can combine the benefits of both strategies!
Taxes after death
What someone would like to do with their money after they pass can have a major impact on their lifetime tax strategy.
Tax deferred bequests
If someone gives a tax deferred retirement account to a family member or friend at their death, the recipient will have to pay income tax. Their heirs essentially pay the tax they didn’t pay during their lifetime.
Regular brokerage and Roth accounts do not generate this kind of taxable income.
Charitable bequests
Because nonprofits aren’t taxed, donating a tax deferred account may save taxes.
It may make sense to bequeath:
traditional retirement accounts to charities and
other appreciated assets to heirs.
Taxable bequests
Assets not in retirement or other tax-deferred accounts usually get a special tax treatment. They receive a step-up in basis.
Let’s say someone passed away and left their home their daughter.
The deceased initially paid $100,000 for a house now worth $1,000,000.
Their daughter received a step-up in basis to the full $1,000,000. She could sell it immediately and not have to pay any federal income taxes!
Federal estate tax. What happened to the $900,000?
The $900,000 effectively went through the federal combined gift and estate tax system. However, it likely didn’t result in any federal estate taxes!
For 2023, the exemption is $12.92 million for an individual. Someone could pass away this month with $12.92 million and pay no federal estate tax.
It gets a little technical. However, their spouse could use up their exemption as well and double the estate tax free amount to $25.84 million.
Very few people will leave an estate this large. If so, it might make sense to start giving up to $17,000 (in 2023) to select family members and friends annually. Gifts up to that level are excluded from the combined gift and estate tax calculation.
A charitably inclined individual might also give to nonprofits throughout their life to lower their federal estate tax.
State estate tax
Many states - including New York, Illinois, Washington, Oregon, and others - have a state estate tax.
Their thresholds are often much lower than the federal exemption.
For instance, the state of Washington’s exclusion is $2.193 million in 2023. Estates larger than that are taxed by the state.
If you’re interested in selling your appreciated assets…
Disclaimer
* For simplicity, this article focuses on just two filing statuses: married filing jointly and single.
Other tax statuses for individuals include:
qualifying survivor spouse,
married filing separately, and
head of household.
In addition to the usual disclaimers, neither this post nor this image includes any financial, tax, or legal advice.