This is the time of year when many of us count our blessings, and if you own stocks and mutual funds, you probably have a lot of blessings to count. But eventually, most of us must share some of our good fortune with the IRS. As the year comes to a close, consider strategies to hang on to more of your bull-market bounty.
Watch out for mutual fund capital-gains distributions. Mutual funds are required to distribute all gains from the sale of their investments, along with the dividends and interest they earn each year. Unless you own the funds in a tax-advantaged account, such as an IRA or 401(k) plan, you’ll have to pay taxes on those gains with your 2014 tax return, even if you reinvest the money in new shares rather than taking it in cash.
Capital-gains distributions from mutual funds were up last year and are likely to go up even more this year, says Tim Steffen, director of financial planning for Robert W. Baird & Co., a wealth management firm. If you get a sizable distribution, consider selling stocks or funds that have declined in value to generate losses to offset those gains. (But don’t sell shares to lock in a loss and expect to buy them back in hopes of riding a rebound. The IRS “wash sale” rule bars you from claiming the loss if you buy the same or a “substantially identical” investment within 30 days of the sale.)
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Be careful, too, that you don’t inadvertently buy a big tax bill. If you plan to purchase a mutual fund for a taxable account between now and the end of the year, wait until after the fund has distributed capital gains. Otherwise, you’ll wind up paying tax on what is effectively a refund of part of your purchase price (the fund’s share price will drop to reflect the distribution). The distribution date should be posted on the fund’s Web site.
Dodge the surtax. For the second year, investors with adjusted gross income (AGI) of $200,000 or more ($250,000 for married couples) face a 3.8% surtax on unearned income, including interest, dividends, royalties, rents and capital gains. The surtax is owed on your investment income or the amount by which your AGI exceeds the threshold, whichever is less. If you’re close to the threshold, consider waiting until next year to sell appreciated securities, says Dan Phillips, a certified public accountant with Schneider Downs, in Pittsburgh.
If you haven’t fully funded your tax-advantaged retirement accounts, there’s still time to funnel money into them. This strategy will reduce your taxable income and your AGI, which could allow you to mitigate or even avoid the surtax. In 2014, employees younger than age 50 can contribute up to $17,500 to a 401(k) or other employer-sponsored retirement plan; those 50 and over can save up to $23,000.
Take advantage of the 0% capital-gains rate. If you’re in the 10% or 15% tax bracket, you qualify for the 0% capital-gains rate on long-term capital gains. For 2014, that means married couples with AGI of $73,800 or less (and singles with AGI of $36,900 or less) can sell stocks or mutual funds and pay no federal taxes on their long-term gains. Steffen says he ordinarily doesn’t recommend letting taxes drive investment decisions, but he makes an exception in this case. If you qualify for the 0% capital-gains rate, you could sell shares of a stock or mutual fund that has racked up a lot of gains and pocket 100% of the profits.
The wash-sale rule doesn’t apply to investments with gains, so if you’re still enthusiastic about the stock or fund, you can repurchase it immediately. This strategy also has the advantage of raising the investment’s cost basis (the price you pay for the shares), which will reduce future gains.
As attractive as this strategy appears, it requires finesse. When you sell stocks or funds, your gains lift your taxable income. Sell too much and you could push yourself out of the 15% tax bracket, which means you’ll end up paying taxes on some of your profits. To avoid taxes entirely, you’ll need to calculate the amount of gains you can reap before your income exceeds the threshold.
In addition, if you’re receiving Social Security, cashing in your winners could trigger taxes on your benefits. Once your “provisional income”—your adjusted gross income plus 50% of your Social Security benefits plus any tax-free interest—exceeds $44,000 on a joint return ($34,000 if you’re filing single), you’ll likely owe taxes on 85% of all of your benefits. Capital gains are included in the calculation of provisional income, even when they’re tax-free. Also, note that a rising AGI might reduce the size of a medical expense deduction (if you’re among the relatively few taxpayers who can claim that write-off). Note also that your state may tax long-term gains that go tax-free at the federal level.
Give it away. Appreciated securities make great gifts, especially if your adult children or parents are in the 10% or 15% tax bracket (and you’re not). When they sell their securities, gains that would have been taxed at up to 23.8% on your return will be tax-free on theirs. The holding period for the long-term capital-gains rate includes the time you owned the securities, so your recipients don’t have to wait a year to sell.
In 2014, you can give cash, securities or other property valued at up to $14,000 to as many individuals as you like without filing a gift-tax return. In the past, wealthy families used this annual exclusion to transfer assets to their children and avoid the federal estate tax. That’s no longer a problem for the vast majority of families. The federal estate tax exemption, which is adjusted for inflation, is $5.34 million in 2014, or $10.68 million for married couples. However, 12 states and Washington, D.C., have a lower estate tax exemption. If you live in one of those jurisdictions, reducing the size of your estate is still a smart move.
Give securities to charity. Sure, the ALS Ice Bucket Challenge was fun. But before you fall for the next stunt for charity, consider donating appreciated securities instead of writing a check. Most taxpayers get a bigger tax break that way, Steffen says.
Here’s why: When you donate appreciated securities you have owned more than one year to charity, you can deduct the value of the securities, based on their worth when you make the gift. You won’t have to pay taxes on capital gains, and the charity won’t have to pay them, either. Plus, you’ll stay warm and dry.
Not all charities can accept donations of appreciated securities. If your favorite cause falls into that category, consider opening a donor-advised fund. The fund administrator will sell the securities for you and add the proceeds to your account. You can deduct the value of the securities on your 2014 tax return and decide later where you want to donate the money. (For more about donating to charities and donor-advised funds, see Make the Most of Your Charitable Giving.)
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