How do you reset the cost basis for stocks and mutual funds to save taxes for low-income earners?

My children, aged 24 and 22, inherited some money in 2014. These funds were invested in stocks and mutual funds. They have gained around $16,000 for each child. My children’s earned income in 2017 will be less than $15,000 each. Would it be advisable to sell, and repurchase the stocks and mutual funds, to reset the cost basis? My understanding is that there are no capital gains tax as long as their earned income is less than $35,000. I think it could save each of them around $2,000 in future taxes.

Investing, Mutual Funds, Stocks, Taxes
Answers
Sort By:
Most Helpful
January 2018
50% of people found this answer helpful

Great question and it’s smart to plan ahead and take advantage of the lower tax brackets.

The strategy you’re describing is commonly called tax gain harvesting.  Federal tax law taxes long-term capital gains (LTCG) at a zero rate if your overall taxable income (including the LTCG) is within the 15% tax bracket (now the 12% bracket with the new tax law).  It’s too late to take advantage of this strategy for 2017 as the stocks or mutual funds would have to be sold by December 31, 2017. 

You don’t provide their expected income for 2018, so I’ll assume it’s the same as 2017 ($15,000).

If they DON’T harvest the gains, their 2018 income tax liability would look something like this (ignoring other possible taxable items like interest, dividends, etc.):

Earned income            15,000

LTCG                                    0

Total income                15,000

Standard Deduction   (12,000) (per the new tax law; no personal exemptions allowed)

Taxable income             3,000

Tax Due (10% bracket)    300

 

If they DO harvest the gains, their 2018 Federal tax liability would look like this (again, ignoring other taxable items):

Earned income            15,000

LTCG                           16,000

Total income                31,000

Standard Deduction   (12,000)

Taxable income           19,000

The 12% bracket (for an individual) ends at $38,700 of taxable income, therefore, they are solidly within that bracket and the LTCG would be free from any Federal Income Tax.  The remaining $3,000 income would be taxed at 10%, or $300, which is the same amount of tax incurred if they didn’t harvest the gains.  For no Federal Income Tax costs, they can “step-up” their basis in their holdings!

 

A few notes:

As they are harvesting gains (instead of losses) in this example, the 30-day wash sale rule doesn’t apply.

Keep in mind that we have not discussed any potential state tax liability, so please consult the laws in your state to determine what, if any, state tax liability may be incurred.

Lastly, with their low tax rates, they should consider funding Roth IRA’s for the year!  No current tax savings for doing so but imagine what 60 years of tax-free compounding would do!

 

Hope this discussion helps.  Feel free to contact me if you have additional questions.

John Madison