States taking their own capital gains bites, from big to small

Warning: Don't overlook the implication of state income taxes, ordinary income or capital gains

Feb 24, 2014 @ 11:10 am

By Darla Mercado

With Tax Day less than two months away, it's probably a good time to remind clients of the levies they'll likely see on state capital gains taxes.

Over the course of the last year, advisers and accountants have kept a close eye on the American Taxpayer Relief Act of 2012 and its effect on federal taxes. There's a large tax bill coming down the pike in April for many of the highest earners. Single filers with taxable income over $400,000, and married taxpayers who file jointly and have taxable income over $450,000 will face a top marginal income tax rate of 39.6%. They will also be subject to a top marginal tax rate of 20% on long-term capital gains, and a 3.8% surtax on net investment income — the latter applies to singles earning over $200,000 and married-filing-jointly taxpayers with more than $250,000 in income.

(More: Where the rich pay the most capital gains)

Those federal taxes are a doozy, particularly the capital gains taxes after a year of strong returns. And that's not it — the states will also have their due in the form of capital gains levies.

State levies are generally off of the radar. “Advisers and investors overlook the implication of state income taxes, whether ordinary income or capital gains,” said John Nersesian, managing director of wealth management services at Nuveen Investments. “The primary focus is on federal taxes, but the state taxes shouldn't be ignored.”

(See also: The capital gains vacation is coming to an end)

Most states tax capital gains as they would ordinary income. This is great news for people who live in a handful of jurisdictions, including Florida, Texas, South Dakota and Wyoming, which don't have an individual income tax.

It's terrible news for Californians, who pay a 13.3% rate on state income and capital gains taxes. New Yorkers don't fare much better, with a state income and capital gains tax of 8.8%, according to a recent white paper by the Tax Foundation. Add the 20% long-term federal rate and the 3.8% federal net investment income tax to those numbers, plus the impact of phased-out deductions, and you're going well over 30% in levies on capital gains.

(Check out these 5 tax breaks for charitable giving)

The average U.S. tax rate is around 28.7%, accounting for federal, state and local rates on capital gains and considering the Pease limitation — a phase-out of itemized deductions — and the state deductibility of federal taxes, according to the Tax Foundation's paper.

“Capital gains taxes represent an additional tax on a dollar of income that has already been taxed multiple times,” wrote Kyle Pomerleau, an economist with the Tax Foundation and author of its recent paper, “The High Burden of State and Federal Tax Rates.”

Raising awareness of state capital gains taxes and their quirks has been no easy feat for financial advisers. It's even more difficult for clients in certain jurisdictions.

For instance, some states don't permit capital loss carry-forwards, so the timing of triggering gains and losses in the same calendar year is crucial, according to V. Peter Traphagen Jr., a partner at Traphagen Financial Group. That makes filing taxes a messy affair. Losses can be carried forward on a federal return and can mitigate tax liabilities in a year that a client receives strong returns and faces a capital gains tax. In New Jersey, however, that same client will still owe taxes on those gains.

“New York and Connecticut allow carry-forwards, but in New Jersey we have to do some extra planning,” said Mr. Traphagen. “It's the timing of tripping the gains and the losses. You want to try matching them in New Jersey. This is a material problem since state income [and capital gains] rates can be as high as 9%.”

It probably doesn't help that last year was a good one for the stock market. The recovery of the markets since the 2008-09 recession means that many of the capital losses clients logged in the past probably have used up.

“If you have a big capital gain, looking for losers in the portfolio is a good thing to do,” said Mary Kay Foss, an accountant with Sweeney Kovar. “For a while, everyone had capital loss carry-forwards, but in 2012 the losses were absorbed, and they probably will be in 2013, too.”

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