Although we don’t give investment advice, we thought a simple math formula that helps you maximize your stock gains might be useful.
Let’s start with the basics of how the Long-Term Capital Gain tax works.
If you sell an investment that you’ve owned for more than 12 months, any increase in its value from its cost basis is taxed at a Long-Term Capital Gains tax rate. This is 15 percent for most individuals, but can go as high as 23.8 percent for those in the top income-tax bracket of 39.6 percent, who are subject to the 3.8 percent Medicare surtax on investment income.
It can get worse for many of our clients:
You pay more to the IRS when the profit is from the sale of an asset held for less than 12 months. A short-term gain is taxed at the higher rates applied to ordinary income from sources like salaries and pensions.
Thus, we have a conundrum when the gain increases at about the same time your holding period is approaching 12 months.
Do you sell now and realize short-term gains, so as to nail down profits, causing them to be hit with the same rates as ordinary income?
Or is it smarter to wait until the profits become long-term and risk a declining price that can more than offset the lower taxes?
Let’s say that Joe Taxpayer’s regular income-tax bracket is 25 percent (for 2014, taxable income between $36,900 and $89,350 for single and between $73,800 and $148,850 for joint filers) and he has an unrealized gain on Microsoft stock which has been owned for 11 months and 10 days.
On the one hand, our client fears a drop in price due to the new Apple products to be released next month (30 days away).
On the other hand, selling now assures more tax on the gain, and thus, less money left in Joe’s account.
Selling now means paying a 25% Federal tax but, if held another 21 days, the gain would be taxed at 15% ( a 13% increase in the gain percentage.)
At this point, Joe is wondering just how much the stock could drop before the reduced price would be offset by the tax savings.
Fortunately for Joe, a simple computation can give him the answer.
Here are the three simple steps:
- Calculate the after-tax return on the short-term gain;
- Divide the amount above by the after tax return on a long-term gain; and
- Multiply the short-term gain by this percentage.
Presto! Joe now knows exactly how much the stock can drop and be offset by the long-term rates.
Let’s test this for Joe. Assume that the profit as of today is $10,000. The combined federal and state brackets for his gains is 30 percent for short-term and 20 percent for long-term. A $10,000 gain (ignoring sales commissions) taxed at 30 percent equals tax of $3,000 and leaves Joe’s account with $7,000. The same $10,000 taxed at 20 percent leaves the account with $8,000. Divide $7,000 by $8,000; the resulting percentage is 0.875. Multiply $10,000 by 0.875 and the result is $8,750. A smaller long-term profit of $8,750 taxed at 20 percent produces $7,000, as much as would be received if the Microsoft holding were sold for a $10,000 gain and be taxed at 30 percent.
So, in our example, our client need not worry until the paper profit drops from its present $10,000 to below $8,750—that is, by more than $1,250.
Simple math – but it can save you a lot.
He is also a founding Board Member and Finance Director of the Fayette Pregnancy Resource Center and serves on the Board of the National Equal Rights Institute.
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