Given the recent bull market, you may have achieved sizable gains in your investment accounts. While this is a welcome development, it also presents a potential concern: capital gains taxes. In addition, capital gains tax rates may increase soon — particularly for high earners — because of recent proposals from the Biden administration and congressional Democrats. 

We provide an overview of where capital gains taxes stand today and suggestions on how investors can manage their capital gains tax exposure. We also highlight the value of a team approach to ensure that any tax-related decisions stay aligned with your overall financial plan and investment strategy.

What are capital gains taxes? What are the current rates?

If you sell appreciated assets that you have held for one year or less, you will owe taxes at the short-term capital gains rate — the same as your ordinary income tax rate. If you sell assets you have held for at least one year and one day, you will owe taxes at the long-term capital gains rate.

If you’re married and filing jointly, current capital gains tax rates are as follows:

• 0%: For taxpayers with taxable income from $0 to $80,800
• 15%: For taxpayers with taxable income between $80,801 and $501,600
• 20%: For taxpayers with taxable income over $501,600

Capital gains taxes only apply to your taxable accounts, not to tax-advantaged accounts such as IRAs and 401(k)s. Once you retire and sell investments from these accounts, you will pay taxes on the total distributions — the gains as well as your initial investment amount — at your ordinary income tax rate.

Historically, capital gains rates have fluctuated, particularly when control of the White House and Congress changes hands. The Biden administration initially proposed treating capital gains the same as ordinary income for taxpayers making more than $1 million annually and raising the top income tax rate. Under this initial proposal, the long-term capital gains tax rate would have increased from 20% to 39.6% for the highest income bracket, plus a 3.8% surtax on net investment income, for a total rate of 43.4%.

However, in September 2021, House Democrats issued a new, less onerous proposal. The updated proposal includes a top long-term capital gains tax rate of 25%, or 28.8% when combined with the 3.8% surtax on net investment income. The new capital gains rate would go into effect for gains realized after Sept. 13, 2021. For 2022, the rate would apply to couples filing jointly whose taxable income was over $450,000 ($400,000 for single filers).

The Democrats’ updated plan would keep Biden’s proposal to increase the marginal income tax rate from 37% to 39.6%.  But since Biden has been firm on not raising taxes for households whose income is under $400,000, it appears that the lower long-term capital gains tax brackets will not change. Therefore, the new base rates for long-term capital gains taxes would be 0%, 15%, and 25%.

Four ways to help manage capital gains.

For now, the Democrats’ proposal remains just that — a proposal — and its fate in Congress is still unclear. If you are in the income group that could be affected by the new rates, there is no need to rush to take action. In fact, because the proposed increase in the Democrats’ current bill applies to gains recognized after Sept. 13, 2021, the window for recognizing gains before the increase has already closed. But whatever your income level, you may be interested in understanding how you can manage capital gains taxes.

Option 1: Gift the gains. If you gift appreciated assets to someone, you can avoid the long-term capital gains tax liability you would otherwise face. The beneficiary will receive your cost basis (your original purchase price plus reinvested dividends and distributions), adjusted for any gift taxes you might pay. When selling the assets, the beneficiary’s capital gain is the difference between the cost basis and the current market value. This approach may be additionally appealing if someone in one of the highest capital gains brackets gifts the asset to someone in a lower bracket.

Option 2: Donate the gains. When you donate appreciated stocks to qualified charitable organizations, you can avoid the capital gains tax implications and receive a tax deduction equal to the stock’s fair market value. And because it’s a tax-exempt organization, the charity avoids paying taxes on the gains as well. However, keep in mind that your total charitable deductions are limited to a certain percentage of your adjusted gross income.

Keep in mind that in some cases, you can be too generous with your gifts. While large charitable organizations can accept huge amounts of appreciated stock, smaller, local charities may not have the resources to handle donations of that size. In these instances, you may want to establish a donor-advised fund.

Donor-advised funds allow you to spread your donations over several years, making it easier for smaller charities to accommodate your generosity. These funds provide the same tax benefits that you would receive from other charitable gifts, including avoiding capital gains taxes and a tax deduction for the total amount in the year of the gift. The investments in your donor-advised fund can continue to grow tax-free, with the potential to increase the value of your charitable contributions, and you get to retain control over when and to which charities gifts from the donor-advised fund are distributed.

Option 3: Keep the gains and manage them. It may be advantageous to retain your appreciated assets and the accompanying capital gains depending on your situation. For example, you could take out a collateralized loan against the assets, which would allow you to benefit from the value of the assets without selling them and recognizing the capital gains. If you then leave the assets in your estate, your heirs will receive a step-up in basis to fair market value. There have been periodic attempts to eliminate the step-up provision, but we believe they are unlikely to succeed given the extraordinary challenges involved in tracking and auditing the cost basis of investments over time.

Option 4: Sell the gains in a year in which you expect lower income than usual. Under some circumstances, such as when your adjusted gross income (AGI) may be lower than normal, you may be able to sell appreciated assets in a way that avoids significant capital gains issues. You could experience several of these years between age 65, when you might retire, and 72, when you are required to start taking withdrawals from your traditional IRA accounts.

The value of a team approach— no matter which route you choose.

Determining the best path for your capital gains exposure depends on circumstances unique to you and your financial plan. Remember that managing capital gains is not just a tax-related decision — it is an investment and portfolio management decision as well. That is why it can be so valuable to work with a team of advisors — including your tax advisor, financial advisor, and portfolio manager. All of them can contribute to a strategy appropriate for your needs and aligned with your overall goals.

At Leelyn Smith, we provide tax, investment, and financial planning support under one roof because we believe in a holistic approach to managing your financial life. Contact a Leelyn Smith advisor to learn more about how we can help you and your family manage your capital gains exposure in the best way for you.