No one likes paying taxes…even though a high tax bill can be considered a ‘good problem.’ Investors sometimes go to great lengths trying to reduce or eliminate their tax bill. Although being tax-efficient with your investments and financial decisions is a great way to maximize your wealth, making purely tax-driven choices may be short-sighted. In general, the only ways investors with gains can avoid paying tax is to simultaneously realize enough losses or give away the assets. For charitably inclined investors or individuals looking to make a tax-efficient gift to loved ones, one of these strategies may be right for you.
Donating appreciated securities
When you give appreciated long-term stocks, bonds, or mutual/index funds you avoid incurring the capital gains taxes that would otherwise have been incurred when you sold the security. If you itemize your deductions, you may also take a charitable deduction for the fair market value of the asset when it was donated, up to of 30% of your AGI (there is a five-year carry forward for unused deductions).
Publicly traded and non-publicly traded assets can be donated, the latter requiring an independent valuation, which increases the cost of this strategy. Though there are numerous ways to donate appreciated securities, a donor-advised fund is perhaps the most streamlined method. Several of the major financial institutions offer donor-advised funds on their platform.
Here’s how it works: when you make an irrevocable donation to your donor-advised fund, you receive an immediate charitable deduction for the fair market value of the asset as an itemized tax deduction and you also do not have to pay capital gains tax on the appreciation. The security is sold when you make the donation and your donor-advised fund receives cash which can be re-invested in the market as you choose. You will also have full control over which charity receives the cash donation and when, provided it is an IRS-qualified public charity.
Keep in mind that with the recent tax law changes, many taxpayers no longer itemize their deductions, which may minimize the effectiveness of charitable donations as a tax strategy. Work closely with your tax advisor to determine how your philanthropy dovetails with your taxes.
Who should consider this strategy: an investor who is charitably inclined and has investment assets with significant long-term appreciation.
Offset investment gains by realizing losses
Although the bull market in the last 10+ years may make it difficult for investors to come up with losses sufficient to offset substantial gains, in certain situations netting gains against losses may be advantageous.
To estimate what your potential tax liability might be, first net your projected short-term gains with your short-term losses. If your losses are greater than your gains, you’ll end up with a short-term loss, and vice versa. Next, net your expected long-term gains against your long-term losses. Once again, you will have either a net long-term gain or loss.
The final step is to net the resulting short and long-term figures to arrive at a net short or long-term gain or loss. Capital gains will be recognized in the current tax year. Capital losses can be used to offset ordinary income up to the lesser of $3,000 or the total net loss. Any unused losses can be carried forward to future years.
As far as taxes go, keep in mind that long-term capital gains rates are taxed at much more favorable rates compared to ordinary income and short-term capital gains (where the same rates apply to both). In 2019, the tax rates on long-term gains range from 0% to 20%, though high income taxpayers may face an additional 3.8% Medicare surtax.
Before placing any trades:
- Consider whether a simultaneous sale aligns with your investment objective. If you’re simply selling the positions to reduce tax, you may be doing yourself a disservice in the long run. Further, if you place the trades early in the year, your tax situation may change by December
- Consider whether a systematic approach to realizing a portion of your investment gains annually and/or in combination with some of the other strategies discussed here may be more appropriate
- Remember the wash-sale rules: the IRS does not allow a deduction if an investor trades a security at a loss and within 30 days before or after the sale buys a ‘substantially identical’ security
- Consult your tax advisor about whether your plan aligns with your overall tax situation and if there will be any changes to your quarterly tax payments to avoid an underpayment penalty
Who should consider this strategy: individuals with a highly-appreciated and concentrated stock position as well as significant losses from other investments and are looking to diversify or raise cash.
Exclude a required minimum distribution from your taxable income
Retirees over age 70 ½ may be able to reduce their taxable income by donating their required minimum distribution (RMD) from their IRA. Excluding Roth IRAs, all other types of tax-deferred retirement accounts require individuals to begin taking annual disbursements at age 70 ½.
RMDs are included in a taxpayer’s ordinary income, which can significantly impact their entire tax situation, including increase their marginal tax bracket, trigger the 3.8% Medicare surtax, cause Social Security income to become taxable, and even sharply increase Medicare Part B and D premiums.
When a retiree utilizes a qualified charitable distribution (QCD), their required minimum distribution from the IRA is donated directly to a 501(c)(3) organization, bypassing an inclusion in the investor’s ordinary income.
- A qualified charitable distribution does not provide a charitable deduction for taxpayers– regardless of whether the individual itemizes their deductions
- An individual can donate up to $100,000 annually using a qualified charitable distribution, even if it exceeds their required minimum distribution. If you are married and file your taxes jointly, your spouse can also make a QCD in the same amount from one of their retirement accounts, provided the other criteria are met
- Qualified charitable distributions can only be made from traditional IRAs – not 401(k) plans, SEP or SIMPLE IRAs.
- The IRS will satisfy your annual RMD starting with the first dollars to be withdrawn from the account, so plan ahead if you take monthly distributions
- Donations must also go directly to the qualified public charity from your custodian. Talk to your financial and/or tax advisor for reporting requirements
- There’s a 2-year lookback for the purpose of calculating Medicare premiums, so be sure to carefully plan your strategy with the other considerations in mind
Who should consider this strategy: QCDs are perhaps best utilized when an individual does not need the income from their required minimum distribution and is charitably inclined.
Giving stocks to family or friends during your life…or at death
If you have appreciated stocks, bonds, ETFs, or mutual funds in a taxable account and aren’t sure how to modify your holdings without incurring any negative tax implications, consider gifting the assets to a family member or friend during your lifetime or at death.
When you gift appreciated assets during your life, you transfer the ownership without selling the position. The recipient of the gift will assume your cost basis. When you make a gift to family or friends, you won’t receive any consideration in return (e.g. continued income from the asset, tax deduction, etc.) so your primary motive must be the desire to gift the asset rather than tax reduction.
Gifting strategies can quickly get complicated, so be sure to discuss your plans with your estate planning attorney, tax advisor, and financial advisor before taking any action.
Here are just two of the considerations to keep in mind about gifting investment assets during your life:
- In 2019, a gift of more than $15,000 per year per non-spouse recipient may count towards your federal lifetime exemption of $11.4M before triggering the gift tax. The amount of the gift is the fair market value at the time the gift is made. Your entire estate must stay below the $11.4M threshold before triggering the federal estate tax, which is why you’ll want to work with an attorney to discuss your situation.
- If you gift a stock or bond to a child or young adult under age 24, the income may be subject to the ‘kiddie tax’ which, at a high level, is currently taxed at the high tax rate which applies to trusts. Likely not the outcome you were looking for! The assets may also hurt the child’s chances for college financial aid, as student-owned assets are considered more heavily in the calculation. Speak with your team of professionals first.
- By gifting low-basis assets, you are just transferring the tax pain to the recipient further down the line – be sure that they are aware of this fact and can plan accordingly.
Typically, when you leave the appreciated assets from a taxable account to a loved one upon your death, the beneficiary will receive a ‘step-up’ in basis to the market value of the securities on the date of your death, assuming you maintained ownership at the time. This could potentially allow your beneficiary to liquidate the shares and pay very little, if anything, in long-term capital gains taxes (gains are considered long-term in this situation, regardless of your beneficiary’s holding period).
Of course, there are various caveats to keep in mind. Here are just a few:
- The assets may still be subject to the federal estate tax if your estate is over $11.4M in 2019. Many states also have their own estate or inheritance taxes, so be sure to consult an estate planning attorney in your area.
- Again, depending on how the assets were titled, the securities may be subject to probate. The probate court is a long and costly process which is triggered when a decedent dies and owns assets individually, outright (not in a trust), and the assets do not otherwise pass directly such as using a payable-on-death election.
- The same considerations when making a gift to a child under age 24 during life (above) also apply to gifts at death.
Who should consider this strategy: individuals with a desire to leave a legacy or make gifts to loved ones during life and may benefit from non-cash efficiencies.
Tax-minded vs tax-centric planning
These tax-efficient planning strategies are best applied when layered onto a gift, sale, or donation you were looking to make anyway. Otherwise, try not to let the thought of paying taxes overshadow the fact that you’ve made money on your investments, especially since that can change. Fear of paying taxes can lead individuals to hold onto a position simply because they don’t want to pay the tax. If the market drops or news about the company causes the stock to plummet, you may have solved one problem (paying the tax) but substituted it with a much larger one: you’ve wiped out your gains.