Laura Saunders for the Wall St. Journal writes: Chances are your capital-gains taxes are going up this year—and if you aren't careful, you could end up paying more than necessary. Amid the political drama surrounding the "fiscal cliff" negotiations, some investors overlooked significant tax changes kicking in this year. Most notable: those on long-term capital gains, or taxable income from the sale of investments held longer than a year.
Under the old system, there were often only two rates: zero and 15%, depending on your income. Now, there are three tax tiers: zero, 15% and 20%. And that isn't all. There also are three backdoor tax increases that can push your effective rate even higher—to nearly 25%.
Experts say many taxpayers whose rate still is 15% could well owe one-third more than they would have last year. And many top-bracket taxpayers will owe nearly two-thirds more, even if their income is that high only because of a once-in-a-lifetime sale.
"These are significant increases, and they raise the value of tax deferral and careful planning," says Vanguard Group tax expert Joel Dickson.
Investors who have begun to consider these issues—and many haven't—admit to being confused.
"I'm trying to figure out whether it's even worth it to have a taxable account," says Matt Reiland, a 32-year-old oil-industry financial analyst in Farmington, N.M., who now is putting away $1,000 a month.
Fortunately for investors, there still are ways to minimize the hit—and even dodge it. Strategies include carefully timing investment sales, making charitable donations and family gifts with assets instead of cash, and minimizing certain income. With markets approaching record highs, investors need to know them.
To be sure, long-term capital gains still retain many of the advantages investors have cherished for decades.
Unlike wages, capital gains often can be timed. Losses on one investment can be "harvested" and used to offset gains on other investments, even in different years. Up to $3,000 of capital losses still are deductible against "ordinary" income such as wages. And whatever an investor's top rate on gains, it often is far below the rate on ordinary income, which now can be more than 41%.
It isn't just capital gains that are affected by the tax changes. The new provisions also apply to many dividends, and some apply to other investment income, including interest. But these types of income often are more difficult to time than long-term gains.
Where You Stand
This year's changes divide taxpayers into three groups. For joint filers with more than $450,000 of taxable income or single filers with more than $400,000, the tax rate on long-term gains is fairly clear, if painful.
It starts with a flat tax of 20% above those thresholds. Add to that the new "Pease limit," a complex backdoor increase tied to itemized deductions that is named after Donald Pease, a former Ohio congressman. In effect, the Pease limit raises a taxpayer's rate by about 1%, according to experts at the Tax Policy Center, a nonpartisan research group in Washington.
Finally, there is a new 3.8% flat tax on net investment income—unless the investor has sold an actively managed business—for a total of about 25%.
Thus, for a taxpayer already in the top bracket, the tax on a $500,000 gain could rise to about $125,000 this year from $75,000 in 2012.
For taxpayers in the next income tier—couples with $72,500 to $450,000 of taxable income and single filers with $36,250 to $400,000—the effective rate on a gain is harder to predict.
It begins with a 15% flat rate, but taxpayers who cross certain income thresholds owe more because of the 3.8% net investment income tax, the Pease limit and the Personal Exemption Phaseout, or PEP, a backdoor increase that limits personal exemptions.
Here's how it could play out: Say a couple with two children in college and a third soon to go has an adjusted gross income of $220,000. They sell long-held investments to help pay tuition, realizing a $175,000 gain. Although they are in the 15% bracket for long-term gains, just as they were in 2012, they'll owe about $5,500 more than they would have last year due to the new 3.8% tax.
This is where planning can help. If the couple can lower their income by, say, raising retirement-plan contributions or spreading the gain over several years, or both, they might reduce or avoid the extra taxes.
"If they cut this year's gain to $50,000, the $5,500 would drop about $750," says Roberton Williams, a tax specialist at the Tax Policy Center.
The last group are investors who owe zero tax on their long-term gains. They often avoid the 3.8% tax, the Pease limit and the Personal Exemption Phaseout as well.
For couples filing jointly, the zero rate extends up to $72,500 ($36,250 for singles). That might sound like a low cutoff, says Silicon Valley tax strategist Stewart Karlinsky, an emeritus professor at San Jose State University, "but it includes more people than we used to think."
That's because these investors often have large amounts of tax-free income, thanks to municipal bonds or Roth individual retirement accounts. If so, they might be able to realize gains selectively to stay within the zero rate.
Sound complicated? It is—and the alternative minimum tax can make it worse. But careful planning is often worth the effort. Here is what to do to minimize your gains pain this year.
Lower your adjusted gross income. An especially confusing feature of the new capital-gains regime is that while rates are tied to taxable income, for most taxpayers the backdoor increases are tied to adjusted gross income.
That's the number at the bottom of the front page of the 1040. It doesn't include itemized deductions on Schedule A, such as mortgage interest and charitable gifts. Taxable income does.
To avoid the backdoor taxes, it is important to minimize your adjusted gross income. Itemized deductions won't help, but other tax benefits can. Among them: deductible contributions to retirement plans such as IRAs or 401(k)s; moving expenses; business deductions or losses; capital losses; rental-property expenses; alimony payments; and health insurance premiums or health-savings-account contributions, according to Mr. Karlinsky.
Tax-free income from municipal bonds or Roth IRAs won't swell adjusted gross income, either. Converting to a Roth IRA will, however, raise it in the year of the conversion.
Take advantage of "air pockets." The tax code stacks income, deductions and net long-term gains in a way that shrewd taxpayers can exploit.
Here's an example: A retired couple has $70,000 of adjusted gross income before capital gains and $30,000 of itemized deductions. (They might also have tax-free income from munis and Roth IRAs.) According to tax rules, the deductions reduce their income to about $40,000.
This leaves them with an "air pocket" of about $33,000 before they cross from the zero rate to the 15% rate on long-term gains.
If they take a $50,000 gain, nearly $33,000 of it won't be taxable, while the rest would be taxed at 15%. If their income remains constant for two years and they can split the gain between the two years (selling at the end of December and beginning of January, for example), the entire gain could be tax-free.
This is a great tax-code freebie. "People in the zero bracket can even harvest gains and raise their cost basis without owing federal taxes," says Mitch Marsden, a planner at Longview Financial Advisors in Huntsville, Ala. Unlike with assets sold at a loss, there's no waiting period to repurchase assets sold at a gain.
Of course, the value of multiyear strategies depends in part on Congress not changing the law again.
Give appreciated assets to charity. Higher taxes raise the value of making charitable donations with appreciated assets such as shares of stock instead of cash. Under current law and within certain limits, the donor gets to skip the tax and yet take a near-full deduction for the gift.
Strategize family gifts. Are you thinking of giving cash to relatives or friends in the same year that you plan to sell a long-held asset? If your recipient is in a lower capital-gains bracket, consider giving him all or part of the asset instead. Taxpayers can give presents of up to $14,000 per individual per year free of gift tax, and the move can save on capital-gains tax as well.
For example, say a woman wants to give $14,000 to her granddaughter, who is between jobs. If she gives $14,000 of stock shares she bought for $3,000, the granddaughter could sell the shares and pay no tax if her taxable income is below $36,250 this year. But if the grandmother sells the shares herself, the tax bite could range from $1,650 to more than $2,500.
Hold on for dear life. The tax code still forgives capital gains on assets held until death; at that point the asset's full market value becomes part of the taxpayer's estate. Now that the estate-tax exemption is a generous $5.25 million per individual (and indexed for inflation), some investors will find it makes sense to hold appreciated assets until death in order to avoid higher capital-gains taxes.
Consider installment sales. Assets such as land or a business can be hard to sell piecemeal. But an owner could sell the entire asset in an installment sale and spread out a gain over several years, assuming the deal makes overall sense.
Remember the home exemption. Couples who sell a principal residence after living in it at least two years get to skip paying tax on up to $500,000 of gains ($250,000 for singles); only above that does the gain become part of income.
Beware of lower limits for trusts. The new 3.8% tax on capital-gains and other investment income takes effect at $11,950 of adjusted gross income for trusts—far lower than the $250,000 threshold for individuals.
But there is an out: The lower limit applies to income that's retained by the trust, while income that's paid out to beneficiaries is taxed at their own rates.
"This puts pressure on trustees to make distributions," says Diana Zeydel, an estate lawyer at Greenberg Traurig in Miami. Yet the point of some trusts is to retain gains and accumulate assets, or at least to keep the beneficiary on a short tether. These issues require expert help.
Don't be driven by taxes. Don't sell—or hold—an asset just to beat Uncle Sam. Don't do an installment sale if you can't trust the buyer to pay up. And don't make charitable or personal gifts solely for tax reasons.
But if you are going to realize a gain, do pause and plan. Especially for large sales, consider using a tax professional. The Tax Policy Center has a good online tool for making before-and-after estimations at calculator.taxpolicycenter.org.
And keep in mind that the new complexity is daunting even for the pros. Says Donald Zidik, a tax specialist at accounting firm McGladrey in Boston: "We simply can't do back-of-the-envelope estimations anymore."
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