How to reduce your capital gains taxes when selling appreciated stocks

Let's be honest: watching your stock or your company RSUs soar in value is a pretty great feeling. Whether you're a long-term investor who picked a winner or an employee whose equity compensation has taken off, you're in an enviable spot. But along with that flush of success comes a nagging thought: "Now what?" 

Maybe you're eyeing that dream house, thinking about funding your kids' college, or simply wanting to know all your eggs aren't in one basket. Whatever your goal, the weight of potential capital gains taxes can feel like a big deterrent when you’re ready to make a move.

This guide is designed to help you make the most of your appreciated stocks. We'll walk you through the basics of capital gains taxation, share some informed strategies for keeping more money in your pocket, and reveal some often-overlooked tactics for diversifying more tax-efficiently. 

The ins and outs of capital gains taxes

When it comes to capital gains taxes, there are a few basic concepts you should understand to make optimal financial decisions.

What are capital gains taxes?

Capital gains taxes are the taxes you pay when you realize a gain on an investment. For example, if you buy stocks for $100 a share and sell them for $150 a few years later, that $50 per share profit is your capital gain. 

To encourage investment, the government generally taxes capital gains at lower rates than income. Nonetheless, federal capital gains taxes can be as high as 20%, tax payers may also be subject to 3.8% Net Investment Income Taxes (NIIT) of 3.8%, and while some states have low (if any) taxes on capital gains, some states such as New York or California tax capital gains at rates of 10% or higher for high-income households.

When do you pay them?

In most circumstances, you only pay capital gains taxes when you “realize” a gain – typically by selling your investment. Before you sell, your gains are considered “unrealized.” So, if you hold stock that has skyrocketed in value on paper, you're typically not on the hook for capital gains until you liquidate your position. Taxes are ultimately due when you file your taxes for the year you sold the asset.

Some types of assets, like real estate, can have exemptions that can allow you to defer capital gains when you sell. But with stocks, you have to pay taxes when you sell.

Long-term vs. short-term capital gains rates

The government also wants to encourage long-term investing, so they've set up the rules that favor patience. Established capital gains rates are lower for investors who hang onto assets for longer:

• Short-term gains (assets held for a year or less): These are taxed like your regular income, with federal tax rates ranging from 0% to 37%, depending on income. 
• Long-term gains (assets held for more than a year): Federal tax rates are typically 15% or 20%, depending on your income level (see table below).

State capital gains taxes

If you're in a high tax bracket, especially in states like New York and California, state taxes and NIIT can significantly increase the amount of capital gains taxes you’ll incur.

To calculate your overall capital gains tax rate, add your federal rate to your state’s rate, and add NIIT if applicable. You may want to check with your accountant to make sure you’re getting these numbers right, but here’s a quick look at how to calculate your long-term capital gains by using the Federal and California rates:

Once you have your federal rate, add 3.8% for Net Investment Income Tax if you’re a single filer with income over $200,000 (or over $250,000 for joint filers).

On top of these two federal taxes, the state of California taxes capital gains like ordinary income. That can mean you’ll be taxed on up to 13.3% of your gains, depending on your income level. The state makes no distinction between long-term and short-term capital gains:

All tax rates as of September, 2024. See up-to-date rates here. 

If you earn over $1M in California, your capital gains rate will be 37.1%, which is the sum of the three taxes listed above:

1. 20% Federal Long-Term Capital Gains Tax, plus
2. 3.8% Net Investment Income Tax, plus
3. 13.3% California State Income Tax

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What capital gains taxes do to a portfolio

If you’re sitting on significant unrealized gains from an appreciated stock, you’re probably in a good place financially. However, reducing concentration risk by diversifying can put you in an even better position for long-term success.

Unfortunately, selling to diversify reduces your principal, which leaves you with a smaller investment to compound over time. It can take years for your portfolio to recover from the impact of this tax drag:

This chart is for illustrative purposes only, and is designed to show the impact of paying taxes, is not a recommendation to buy META or any other security and is not indicative of any specific market situation.

Imagine, for example, that you were an early employee at Meta and you wanted to diversify $100K of stock with a cost basis of $20K. Selling to diversify might mean paying $35K or more in taxes in a high-tax state like California.

However, if you could diversify without selling, your $100,000 would have more growth potential over time – even after taxes are ultimately paid. If your diversified investment returned 10% annually after expenses for 10 years and your tax rate stayed the same, you’d wind up with an additional 27% in after-tax returns:

The hypothetical above assumes a cost basis of $0, a combined long-term capital gains rate of 35%, and a 10.7 % annual return gross of fees and expenses, with a hypothetical expense of .7% annually  (fees and expenses would lower your overall investment returns) after the stock is exchanged for a diversified investment. 10% annual net rate of return. * S&P 500 and Nasdaq 100 are unmanaged indexes representative of a market-capitalized weighted index of 500 leading publicly traded companies, NASDAQ 100 is a market-weighted index of the 100 largest non-financial companies in the NASDAQ.  You cannot invest directly in an index.

Strategies for tax-efficient diversification

When it comes time to diversify, what’s the optimal strategy for your portfolio? It can vary greatly, depending on your circumstances, but here are a few potential strategies for reducing taxes that you may want to consider before you sell. We’ll also cover when different tax optimization strategies can be a good fit.

Strategy 1: Wait for long-term gains

Tax regulations are designed to reward patience, and you can save significantly on capital gains by holding assets for at least a year. If you’ve accumulated stock-based compensation over time, this may be a moot point, but it’s worth calling out because paying taxes at short-term gains rates can be painful – and it can exacerbate the impact of tax drag.

As of October 2024, for example, Nvidia stock has been up over 150% over the past 11 months. Someone in California’s top tax bracket who bought NVDA in October 2023 and sold in September 2024 could wind up paying 37% in federal income taxes, 13.3% in California taxes, and 3.8% in NIIT. 

In this situation, waiting a month to sell would result in significant tax savings, period. 

Their single stock carries more concentration risk than a well-diversified investment, but the stock would have to lose at least 17% of its value in a month to overcome the benefit of waiting for long-term gains treatment in places like California. 

Strategy 2: Avoid a “sale” if you can

We saw before that deferring capital gains taxes can have a big impact on future growth – but how can you diversify without selling first?

For sophisticated investors with a long-term outlook, there can be several more tax-efficient choices than selling outright:

Exchange Funds

Exchange funds help you diversify by pooling your appreciated stocks with stocks from other investors. Your stocks are exchanged for a share of the fund – without triggering capital gains taxes – and after a 7-year holding period, you can withdraw a slice of the diversified portfolio. Exchange fund managers typically design an exchange fund to be benchmarked to an index, like S&P 500 or Nasdaq-100.  

(However, remember that Exchange Funds are alternative investments intended for sophisticated investors with a long-term time horizon.and the funds are designed to benchmark to the index they are not index funds and do not directly track the index.)

Participating is basically like going to a potluck where everyone brings their choice of a dish, and the goal is that you leave with a well-rounded meal. Better yet, no gains are due until you ultimately sell, which allows you to delay tax drag indefinitely. 

Until recently, exchange funds were typically only available to ultra-wealthy investors, but they’re now available to investors with as little as $100,000 in stocks to contribute. See if you’re eligible.

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Collar Advance

Need liquidity but not ready to part with your prized stock? A collar advance, also known as a prepaid variable forward, lets you borrow against most of the value of your stock while deferring the sale (and the taxes that come with it). A collar advance also limits the potential downside of holding your position, while still allowing you to participate in some of the potential upside if your stock continues to appreciate. However, your upside is capped at an amount specified in the contract. After the term of the agreement you can either choose to roll forward the contract or allow it to expire. 

This approach can be particularly valuable if you need cash, but you believe your stock still has room to grow. As tax treatment can be complex, it is important that you work with your tax advisor. 

Charitable Giving

For those with a philanthropic streak, donating appreciated stocks is a triple win that unlocks powerful giving potential. You support causes close to your heart, sidestep capital gains taxes, and snag a big tax deduction based on the stock's full market value. Take it a step further with a 

A Donor Advised Fund (DAF) can be a good way to optimize charitable giving. With a DAF, you can contribute appreciated stocks now, securing an immediate tax deduction. Stocks continue to appreciate, and you can decide which charities to support over time. It's like having a charitable time machine: lock in today's tax benefits, then spread your giving over years or even decades. The cherry on top? Your contribution can potentially grow tax-free within the DAF, expanding your philanthropic reach far beyond what a simple cash donation could achieve.  

Estate Planning

While it might not help with immediate liquidity needs, smart estate planning can be a game-changer for your legacy. When you pass appreciated stocks to your heirs, they’ll benefit from a step-up in cost basis. They’ll realize your capital gains without potentially wiping out years of growth by paying capital gains taxes. 

Estate taxes may still apply, and there are many different gifting strategies and trust structures you may want to consider during your lifetime. An estate planner can be very useful to navigate the details and make sure your wishes are met.

Strategy 3: Offset gains with losses (or other deductions)

When selling is the only way to diversify, offsetting your gains with losses is a financial move that could significantly reduce your tax burden.

Tax regulations allow you to subtract losses from the capital gains you recognize – which is called “tax-loss-harvesting” – or you can carry unused losses forward to future tax years, functioning like rollover minutes for your finances.

Direct indexing or a Separately Managed Account (SMA) can help you limit capital gains liability by giving you a way to continually harvest losses that offset the gradual sale of appreciated stocks over time. Instead of investing in an ETF or mutual fund, a direct indexing strategy will help you diversify by buying the entire basket of stocks that make up a diversified index fund. 

As those individual stocks fluctuate in value, it presents opportunities to sell some of the basket at a loss, enabling you to sell some of your appreciated stock. As harvested losses accrue over time, it allows you to diversify more and more of your position without paying gains taxes.

Note that a significant cash outlay is typically required to initiate a direct indexing program – which may mean selling and paying taxes on some of your appreciated stock upfront. Nonetheless, many investors find this approach useful for reducing the potential burden of capital gains taxes.

How to make a decision

When you’re managing appreciated stocks, optimizing your capital gains tax treatment can be the difference between watching your wealth grow and feeling like you’re running on a treadmill.

We've covered a lot of ground here, from the basics of long-term vs. short-term gains to some of the fancy financial footwork you might be able to undertake. Now the next step is to assess your needs and hone in on the right approach. A few key factors to consider:

• How big will your tax burden potentially be?
• Do you want to diversify immediately, or are you comfortable unraveling your position over several years?
  Do you need short- to mid-term liquidity for major purchases?
• Do you want to set any assets aside for charity or the next generation?

There's no one-size-fits-all solution – and it may make sense to take advantage of more than one strategy. For example, you might sell some stock for instant liquidity, donate some to a donor-advised fund to offset those gains, and contribute the rest to an exchange fund for immediate diversification and long-term growth potential.

If you’re curious to learn more about how exchange funds can help you manage your tax burden, take a look at our Exchange Fund overview – or take a look at our more detailed guide on how Exchange Funds work. 

<div class="blog_disclosures-text">Cache Securities is a broker-dealer registered with the SEC and is a member of the Financial Industry Regulatory Authority Inc. (“FINRA”) and of the Securities Investor Protection Corporation (“SIPC”), Cache Advisors is an investment adviser registered with the Securities and Exchange Commission (“SEC”). Registration does not imply a certain level of skill or training. Cache Advisors and Cache Securities are wholly-owned subsidiaries of Cache Financial “Cache”.</div>

<div class="blog_disclosures-text">To complete a purchase, an investor must complete and execute a subscription document. Any product discussed within should only be purchased after the client reviews the offering documents and executes a subscription agreement. Cache does not make investment recommendations; investors are responsible for their investment decisions and should carefully consider the risks associated with the investment and decide, based on their particular circumstances, that the investment is within their investment objectives and risk tolerance.</div>

<div class="blog_disclosures-text">The Cache Exchange Funds are alternative investments. Regulations require certain eligibility criteria for participation and are open to either accredited investors or qualified purchasers who have eligibility criteria as specified in the offering documents. Exchange funds are appropriate for eligible, long-term investors willing to forego liquidity and put capital at risk for substantial periods. Regulations require a minimum holding period to realize the potential advantages. They may also have higher fees than traditional investments. While diversification may help spread risk, it does not assure a profit or protect against loss, and investing could result in a loss of your entire existing principal when you invest in securities.  Exchange Funds defer taxation on investments; however, they do not eliminate the need to pay taxes on the sale of assets.  Stock basis will vary based on the time you receive the grant please consult with your tax advisor for information specific to your situation.</div>

<div class="blog_disclosures-text">Collar Advance relies on a fixed-term options contract that may be difficult to unwind in volatile markets. Investors may face potential losses when trying to prematurely exit contracts, particular during challenging or unfavorable market conditions. Although Collar Advance offers certain downside protections, investors may still face absolute losses if share prices decline over time. In addition, investors risk foregoing gains beyond the cap levels set in the contracts. Dividends received on stocks pledged under Collar Advance contracts are not considered qualified dividends and may not receive preferential tax treatment. Cache Securities LLC offers the service in partnership with Fort Point Capital Partners LLC (“Fort Point”) and Uhlmann Price Securities, for which Cache Securities receives a referral fee. Clients do not incur any additional fees by working with Cache Securities LLC</div>

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