Watch out for tax bite after great year in markets

The stock market had yet another record-breaking year in 2020. While that means many portfolios likely ended up in the black, it could also mean substantial tax bills for investors who sold stocks last year — especially those that weren’t tucked inside an individual retirement account, a 401(k) or some other tax-advantaged retirement account.

Investors who sold individual company stocks while the market was up could be liable for capital gains taxes.

“Gains are good. Taxes are bad,” said Robert Fragasso, CEO of Fragasso Financial Advisors in Pittsburgh.

Capital gains only occur when a shareholder sells stock and takes a profit. But it’s not always up to the individual investor when to pull the trigger and realize a capital gain.

“If you own a mutual fund, the capital gains are realized for you,” Fragasso said. “Then you get a 1099 form at the end of the year telling you those gains have been registered for you inside the funds.”

After dropping nearly 20 percent in March as the pandemic first gripped the U.S., the stock market indexes made a powerful comeback and ended the year at all-time record high levels. The Dow Jones Industrial Average gained 7 percent in 2020 and crossed the 30,000 milestone; the S&P 500 gained 16 percent; and the Nasdaq had its best year since 2009, with a 44 percent gain.

Someone who bought Tesla stock in March at its lowest price of $71 and then sold those shares in December at its highest price of $718 would have a capital gain of $647 per share.

While a relatively small segment of American families — 14 percent — are directly invested in individual stocks, more than half of U.S. households — 52 percent — have some investment in the stock market.

Most of this stock ownership comes in the form of retirement accounts, such as IRAs and 401(k) plans, according to the Pew Research Center in Washington, D.C.

Generally, any profit that an investor makes on the sale of stock is taxable at either 0 percent, 15 percent or 20 percent, depending on that person’s taxable income and filing status if the shares were owned for more than a year. Stocks held for less than a year are taxed at the shareholder’s ordinary income tax rate.

Also, any dividends received from stocks are usually taxable. Exactly how much depends on how much you make.

Single tax filers with income below $40,000 can benefit from the 0 percent long-term capital gains rate. However, most single people owning stock fall into the 15 percent capital gains rate, which applies to incomes that fall between $40,001 and $441,000. Single filers earning more than $441,500 face a 20 percent long-term capital gains rate.

Married couples with incomes of $80,000 or less qualify for the 0 percent tax rate. However, couples who earn between $80,001 and $496,600 have a capital gains tax rate of $15 percent, and those with incomes higher than $496,600 will be hit with a long-term capital gains rate of 20 percent.

Higher-income taxpayers with married joint incomes in excess of $250,000 also should be aware that their stock sales could be subject to a 3.8 percent net investment income tax in addition to the capital gains tax.

“We had clients who sold investments in 2020 in anticipation of a possible bump in taxes on capital gains in 2021,” said Alex Kindler, a partner at H2R CPA in Green Tree, Pa.

Those concerns were caused by the upcoming change in presidential administrations, Kindler said. But only time will tell if and when a tax increase is on the way.

“It is unclear, given the status of the pandemic and its toll on the economy and the American people, whether Congress will have the appetite to increase capital gains taxes in 2021,” Kindler said.

Tax strategies

Financial advisors spend much of the year thinking about things like capital gains taxes, even if the average person is not on that program, said Benjamin Greenfeld, chief investment officer for Waldron Private Wealth in Bridgeville, Pa.

“People should be doing tax planning throughout the year instead of waiting until the end of the year,” he said. “Tax planning is a process, not an event. You don’t wake up on Dec. 5 and decide to do tax planning for the year.”

As a wealth manager, Greenfeld periodically rebalances client portfolios throughout the year by selling stocks that had over-appreciated and by buying stocks that appear ready to break out.

The coronavirus crash in March caused stock values to drop like a rock. But it was also a tax-loss harvesting opportunity, he said.

A hypothetical example of the strategy he used during that catastrophic event was if a client owned stock in Coca-Cola Co. that fell from $100 to $75, he sold the stock for a loss of $25, then bought shares of PepsiCo Inc. — the idea being that two companies in a related industry might have similar returns as the market rebounds.

When an investor sells stocks in a down market and losses exceed that initial investment, the IRS allows the investor to deduct the loss on their tax return, up to $3,000 per year.

“The market had a strong run out of the gate,” Greenfeld said. “If you bought Pepsi and Pepsi went up, you’d have the same investment performance as well as a tax asset from the loss.

“If you weren’t being proactive during the volatility, you missed your opportunity to minimize taxes without harming the overall portfolio.”

Matthew Helfrich, president of Waldron Private Wealth, said one tax planning strategy he used to reduce the impact of capital gains was to recommend his clients use equities to fund their charitable requests at year’s end.

“That allowed us to reduce the position while saving on the tax and fulfilling client charitable goals,” Helfrich said.

“Additionally, in some instances it made sense to delay taking gains until 2021, as it would give an extra year of deferral on the tax until it is paid — which works if capital gains rates continue to stay at their current levels,” he said.

Tough choices

Many people don’t pay a lot of attention to capital gains taxes because their investments are in retirement funds. If shares are held inside of a traditional or Roth IRA or a 401(k), the taxes on stock dividends and capital gains are deferred.

As long as the money is held inside one of those qualified retirement investment vehicles and remains in the account, the account owner pays no taxes on the investment growth, interest, dividends or investment gains.

But for non-retirement investment, tax issues can complicate things. Selling shares can be a tough decision, especially when the stock is hot and the stock owner doesn’t have a financial need.

“For stocks to be sold, the trade-off is: Do you think the stock will continue to go up?” Fragasso said. “Well then, why take the gain? Do you think markets are going to fall precipitously? Nobody can predict that. So, that’s fool’s gold.

“But if you feel you have experienced all the gain that you can and the stock is vulnerable because it’s run its full price course, then you take the gain — and pay the taxes.”

Updated: 
01/20/2021 - 9:11am