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Financial Planning > Tax Planning

How to Help Clients Avoid Capital Gains Taxes 

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What You Need to Know

  • Donating appreciated stocks, ETFs, mutual funds and other securities offers a double tax advantage.
  • Capital losses in excess of realized capital gains can be used to offset up to $3,000 of other taxable income.
  • As always, do what's best for the client's overall financial situation.

With the prospect of higher capital gains taxes under the Biden tax proposal, financial advisors will want to look for ways to help their clients avoid these higher taxes on stocks, inherited property and other assets. 

The Biden tax proposal would raise long-term capital gains tax rates to 39.6% for those earning $1 million or more per year. When you add in the Net Investment Income Tax (NIIT) for high-income taxpayers of 3.8%, this raises the top long-term capital gains tax rate from the current 23.8% to 43.4%. In a surprise, he suggested the increases be retroactive to April.

Here are some ways you can help your clients avoid or reduce capital gains taxes. 

Donate Appreciated Securities to Charity 

This is a tax-smart way for your clients with charitable inclinations to donate money even under the current rates. Donating appreciated stocks, ETFs, mutual funds and other securities offers a double tax advantage, so to speak. 

First, the market value of the securities on the date of the donation serves as a charitable tax deduction, provided that your client is eligible to itemize deductions for that tax year. Second, there are no capital gains taxes on the donated assets. Even at current capital gains tax rates, the capital gains taxes on ultra-low basis shares of appreciated stock can be substantial. 

In addition to a direct donation to a charitable organization, your clients can consider a donor-advised fund (DAF). Donating appreciated assets to a DAF offers the same tax advantages to clients as a direct charitable donation. With a DAF, the donated assets are professionally managed, and clients can make donations to accredited charitable organizations over time while realizing the tax benefits in the year the money is transferred to the DAF. 

While most people think of charitable donations in terms of appreciated stocks, mutual funds, ETFs and other securities, other appreciated assets can be donated directly to organizations or to a DAF. These assets could include art and collectibles, real estate and others. 

Use Tax-Loss Harvesting

Be sure to use tax-loss harvesting when appropriate. Tax-loss harvesting involves realizing tax losses on holdings and using these tax losses to offset realized capital gains. This can be done in the course of your regular client portfolio reviews to determine if rebalancing is needed. 

Some advisors will look at their client’s taxable accounts to look for tax-loss harvesting in the course of the year and “bank” those losses for use in offsetting future realized capital gains. Capital losses in excess of realized capital gains can be used to offset up to $3,000 of other taxable income. Any remaining unused losses can be carried over to subsequent years. 

Be Smart About Asset Location 

Asset location is about the types of investments held in various accounts such as taxable accounts and retirement accounts like IRAs and 401(k)s. This has always been something to consider in the course of tax planning for clients. If the proposed higher capital gains tax rates are enacted, this will become a bigger issue for clients who are affected. 

Conventional wisdom has been that assets with the potential for large capital gains, such as stocks, be held in taxable accounts and that income-producing assets like bonds and others be held in taxable retirement accounts. With the current long-term capital gains rates at preferential levels, these gains would be taxed at a lower rate than most clients’ regular tax rates. 

Clients who might find themselves affected by the higher capital gains tax rates may want to consider holding stocks and other investments with the potential to generate sizable capital gains over time in tax-deferred (or tax-free) retirement accounts in order to avoid paying capital gains taxes in the current year. In the case of a traditional IRA or 401(k), distributions are taxed, but the client’s income may be lower at that point. At the very least, this defers any taxation of these gains. 

Convert Traditional IRA Assets to a Roth IRA

Converting traditional IRA assets to a Roth IRA remains a good strategy for some clients in the current low tax rate environment. This can play into helping clients avoid capital gains taxes in several ways. 

First, investing in stocks with high growth potential will permanently negate any taxation of future capital gains for securities held in a Roth. There are no taxes in the year of the gain, and this money can be withdrawn tax-free at retirement if certain rules are followed. 

Second, a Roth IRA can be a way to shield beneficiaries from capital gains taxes if the portion of the Biden tax proposal eliminating the step-up in basis for estates in excess of $1 million should pass. Assets in an inherited Roth IRA are tax-free to beneficiaries upon withdrawal as long as your client had met the five-year rule prior to their death. This includes any capital gains that were realized in the account along the way. 

Avoid Capital Gains Taxes on Inheritances

The potential elimination of the step-up in basis for assets including securities, a small business and others could be very costly to your client’s heirs and serve to deplete a significant portion of the money they’ve intended to pass on.

This may be a good time to discuss potentially revising some aspects of their estate planning to help avoid this issue. This might include the use of trusts or other strategies. 

Sell Appreciated Assets

It might make sense to advise your client to sell appreciated securities or other assets held in taxable accounts prior to the passage of any legislation that includes higher capital gains tax rates. 

As with any transaction, be sure that selling these assets makes sense beyond paying a lower capital gains tax rate. 

Focus on the Client’s Overall Situation

The strategies listed above can help high-income and high-net-worth clients avoid higher capital gains tax rates during their lifetime and in passing their estates to their heirs if these new rules go into effect. 

As with anything, be sure to focus on what’s best for the client’s overall situation. Avoiding potentially higher capital gains rates can be a good idea, but only if it makes sense in the context of your client’s overall financial planning situation. 

Roger Wohlner is a financial writer with over 20 years of industry experience as a financial advisor.