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capital gains tax

Q&A: How to figure your capital gains tax bite so the IRS doesn’t zap you

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Dear Liz: We had big capital gains this year, and we owe taxes plus a penalty for not paying estimated taxes. Is there a way to plan ahead for taxes since every year is different regarding gains or losses? I know one option is to just pay estimated taxes quarterly based on the previous year’s gains. Apparently the mutual fund companies don’t automatically withhold the taxes.

Answer: Our tax system is “pay as you go,” which means the IRS expects you to pay taxes as you earn or receive income. If you fail to do so and your tax bill is more than $1,000, you may face penalties.

As you rightly note, though, you won’t know what your total capital gains or losses will be until year’s end. You wouldn’t want to pay taxes on a big gain one quarter only to have a big loss the following quarter. You can avoid the penalties by making sure your withholding and estimated tax payments equal at least 100% of the total tax you paid in the previous tax year if your income is $150,000 or less. If your income is over $150,000, your payments and withholding should equal at least 110% of last year’s taxes.

The alternative is to pay at least 90% of the tax you’ll owe on your estimated income for the current year. A tax pro can help you figure out how much you need to pay as well as offer tips for reducing your tax bill.

Q&A: What is the capital gains tax, and how big a bite does it take?

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Dear Liz: We own stocks with enormous capital gains — as in, six figures or more. The tax would be a lot. Any advice on how to limit the tax bite? Our income consists of Social Security and a teacher’s pension.

Answer: Capital gains taxes may be less of a problem than you fear. If your taxable income as a married couple is less than $83,350 in 2022, your federal tax rate on long-term capital gains is zero. (Long-term capital gains apply to profits on stocks held one year or more.) If your taxable income is between $83,350 and $517,200, your federal capital gains tax rate is 15%.

In addition, you may owe state taxes. California, for example, doesn’t have a capital gains tax rate and instead taxes capital gains at the same rate as ordinary income.

Capital gains aren’t included when determining your taxable income, by the way, but they are included in your adjusted gross income, which can affect other aspects of your finances. A big capital gain could determine whether you can qualify for certain tax breaks, for example, and could inflate your Medicare premiums. That’s why it’s important to get good tax advice before selling stocks with big gains.

A tax pro can discuss strategies that might reduce a tax bill, such as offsetting gains with capital losses by selling any stocks that have lost value since you purchased them. You also could consider donating appreciated shares to qualifying charities. If you itemize your deductions, you can deduct the fair market value of these shares. The write-off is typically limited to 30% of your adjusted gross income for the year, although if you donate more you can carry forward the excess deduction for up to five years.

All this assumes that these shares aren’t held in retirement accounts. Withdrawals from retirement accounts are typically taxed as ordinary income and don’t benefit from the more favorable capital gains rates. If the stocks are in an IRA and you’re at least 70½, however, you could make qualified charitable distributions directly to nonprofits and the distributions wouldn’t be included in your income. Again, this is something to discuss with a tax pro before taking action.

Friday’s need-to-know money news

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Today’s top story: How shopping small makes a big impact in your community. Also in the news: How Biden’s capital gains tax hike could affect you, 5 key credit card strategies for international travelers, and why fake travel sites are fooling more people.

How Shopping Small Makes a Big Impact in Your Community
Invest in your community.

Would Biden’s Capital Gains Tax Hike Affect You? Probably Not
The average retirement saver should carry on as usual, since capital gains taxes typically don’t apply to investments like 401(k)s.

5 Key Credit Card Strategies for International Travelers
People who spend a lot of time abroad should look for travel credit cards with international perks and partners.

Why Fake Travel Sites Are Fooling More People
Don’t get duped.

Q&A:Don’t make this mistake with your retirement savings

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Dear Liz: My wife and I are in our mid-40s and planning to buy what likely will be the last house we’ll purchase. I’ve decided to withdraw around $15,000 from my IRA to buy down the rate, which will guarantee returns in the form of interest savings, even if those will be less than the returns I would earn if I left the money in the account. My real question is about our current house. We owe around $77,000 on a house that could likely fetch in the low $200,000 range. I’ve looked at it up, down and sideways. Would it make more sense to rent, sell, or rent then sell after a couple of years to avoid the capital gains tax?

Answer: Sometimes it can make sense to buy down a mortgage interest rate by paying more upfront if you plan to stay in the home for many years. The deals vary by lender, but you might pay 1% of the loan amount (one point) to get a rate that’s 0.25% lower, or 2% (two points) to get the rate reduced by 0.5%. For example, paying two points on a $200,000 mortgage, or $4,000, could lower the rate from 4.5% to 4%. You would drop the monthly payment about $59, and it would take you nearly six years for the slightly lower monthly payments to offset what you paid upfront.

You complicate the math, though, when the money used to buy down the rate comes out of a retirement account. That money is taxed as income and would likely be penalized as well because you aren’t yet 59½. (There’s an exception to the penalty for first-time home buyers who withdraw up to $10,000, but they’ll still owe income tax on the withdrawal.) The tax bill varies according to your tax bracket and your state, but you can expect it to equal roughly one-quarter to one-half of the amount withdrawn.

In addition to the tax bill, you’ve also given up future tax-deferred returns on the money. And because most people’s incomes drop in retirement, you’re probably paying a higher tax rate than you would if you withdrew the money later.

A good rule of thumb is to consult a tax pro before you take any money out of a retirement account. The rules can be complex and it’s easy to make an expensive mistake. A tax pro also could advise you about the tax implications of renting vs. selling, although you might also want to talk to anyone you know who’s a landlord about what’s involved with renting out a property.

The simplest solution may be to sell your current home and use the equity to reduce the size of the loan you’ll need on the next residence, rather than raiding a retirement fund to get a slightly lower rate.

Q&A: Tax take on inherited house

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Dear Liz: In a recent column, you quoted an attorney saying that if an inherited home in a trust is sold for its value at the date of death, the trust won’t owe capital gains. We sold our family’s house in 2007 within a month of my mother’s death and the government took half. Fortunately it was a really valuable house in Brentwood, but what are you talking about? I must be missing something.

Answer: If the government took half, then estate taxes — rather than capital gains taxes — probably triggered that hefty bill.

When your mother died, the estate tax exemption limit was much lower — $2 million, compared with the current $11.4 million. The top federal estate tax rate then was 45%, compared with 15% for capital gains.

Q&A: Figuring home-sale taxes

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Dear Liz: My husband and I bought a home in Los Angeles in 1976 for $200,000. He died in 1992. The value of the house was at that time about $850,000. (I had it appraised.)

I want to sell the house now. The value is about $2 million. How much would be the stepped-up base for capital gain tax when I sell it?

Answer: In most states, only your husband’s half of the home would have gotten a new tax basis at his death. (A tax basis is used to determine potentially taxable profit.) In community property states such as California, however, both halves of a property get the step up in basis when one spouse dies.

You can add to your basis any commissions or fees paid to purchase the property and the cost of any additions or improvements. What you spent on maintenance and repairs doesn’t count. The improvement must add to the value of your home, prolong its useful life or adapt it to new uses to qualify, according to the IRS.

To figure your taxable profit, you’ll take the net amount you receive from the sale — the sale price minus any commissions or fees paid to sell the home — and subtract your basis from that. You can exempt up to $250,000 of the home sale profit, but you would pay long-term capital gains rates on the rest.

Let’s say you invested $150,000 in improvements over the years. That would be added to your $850,000 basis for a total adjusted basis of $1 million. Let’s also assume you pay $100,000 in commissions to sell your home, netting $1.9 million. Your $1 million basis would be subtracted from the $1.9 million, leaving you with a $900,000 home sale profit. Because $250,000 of that would be exempt, you would owe long-term capital gains tax on $650,000.