• Stephen Mulholland, CFA

Do Capital Gains Taxes Have to be Paid Quarterly?

Many Americans experienced their first taxable capital gain in 2020 or 2021. The most common forms of capital gains are selling homes and stocks. However, both are usually tax free. Selling a primary home does not typically result in a taxable gain as married couples are not taxed until they generate capital gains over $500,000. Further, homeowners can add a long list of capital improvements to their cost basis to further protect gains. Selling stocks also does not normally generate capital gains taxes as most Americans hold them in tax-deferred accounts like 401K’s and IRA’s.

2020 was not a normal year. Ample time at home, stimulus checks, lower spending in a closed economy, and the advent of free stock trading led countless Americans to trade stocks in taxable accounts for the first time. The ramifications of a new nation of day traders were huge, as evidenced by the GameStop saga. The aftershock of the tax implication is now on the horizon.

The IRS extended the tax deadline from April 15th to May 17th this year for almost all Americans. However, one cohort must still pay tax on April 15th: those that file quarterly. Most quarterly filers are self-employed individuals who do not have tax withholding automatically taken out of their paychecks. But, there is another category that can trigger the necessity to make quarterly tax payments: anyone who generates over $1,000 in capital gains and runs afoul of a somewhat obtuse rule listed in the IRS tax code, which we simplify to the following: if you made a capital gains of greater than $1,000 in a calendar year, you need to ensure your tax withholding for that year is equal to or greater than your tax payment for the prior year.

If you have a material capital gain in the first quarter of 2021 you need to monitor your tax withholding as the year progresses to ensure it will finish higher than your 2020 tax payment. If you have the same job you had last year with the same salary you will most likely be fine. But, if you changed jobs and took a lower salary or saw reduced compensation due to Covid there is a good chance you could violate the rule if you make no changes to your withholding. The best way to avoid having to make quarterly tax payments and worse, pay penalties, is to adjust your tax withholding as needed. Simply locate your tax payment from the year before your capital gain on your form 1040. Identify your total tax withholding for the calendar year of your capital gain. And ensure you withholding in the current year is more than the prior year. You can change your withholding with your employer throughout the year.

With a bit of tax planning, you will be able to pay your capital gains tax come normal annual tax time and face no penalties. With poor tax planning you could end up paying a tax penalty of up to 25% of your capital gain in IRS penalties. Capital gains taxes are significantly lower than ordinary income taxes: either 15% or 20% depending on total compensation. With a bit of tax planning, you can ensure you get the full tax benefit and do not end up negating some of your advantage by paying unnecessary fees. Oh, and congrats on the capital gain!

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