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It was only 15 months ago that Congress passed the largest piece of tax reform legislation in more than three decades. This bill called the Tax Cuts and Jobs Act contains numerous provisions that are having an impact on your taxes. One of many concerns to investors is the capital gains tax. Let’s discuss some of the details of capital gains taxes, what they are and how they work. I’ll summarize the recent changes to the capital gains tax structure and an innovative strategy that can help you minimize your taxes inside of your brokerage accounts.
A brokerage account holds your portfolio of investments, but it’s not considered a tax-sheltered account like an IRA or 401(k) where your investments grow on a tax-deferred basis. If you’re concerned about capital gains, it should be a reassuring feeling because it means your investments have probably performed well. If the assets you hold are now worth more than what you paid for them, you might be thinking about selling some of your holdings for retirement income, an overseas vacation or to purchase that new RV you have been dreaming of. To accomplish this, you will have to realize these capital gains. That’s the good news. The not-so-good news is that your gains are subject to taxation at the federal and the state level.
The amount you’ll pay in capital gains tax is based on the size of your gains, your federal income tax bracket and whether your gains are short-term or long-term.
To determine the extent of your capital gains you’ll need to know the basis of your investment that will be sold. This is the amount you’ve paid to acquire the shares. You don’t pay capital gains taxes on your basis. Your tax liability is based on the difference between the sale price of your holdings and the basis you have in that asset. In other words, your profit. It’s important to consider that your basis includes any fees on the management or purchase of your investments. Don’t forget to factor this into these costs to reduce your tax burden.
Your capital gains tax rate will also vary based on how long you’ve held the investment before selling it─ not how long you’ve had the brokerage account open. Short-term capital gains are defined as gains made on assets that you held for a year or less, while long-term capital gains come from assets you have held for more than a year. The U.S. tax code gives favorable tax treatment to long-term gains relative to short-term gains. This difference can be substantial for tax-sensitive investors as the tax rate applied to investors in the highest tax bracket for long-term gains currently stands at 20%, compared to 37% for short-term gains. This is because short-term capital gains are taxed as ordinary income. This means any income you receive from investments held for less than a year must be included in your taxable income and taxed at the higher rates as your paycheck or IRA distributions. Long-term gains are taxed at lower rates of 0%, 15%, or 20%, depending on your tax bracket.
Under the Tax Cuts and Jobs Act, there are now lower marginal tax rates and different income thresholds for most tax brackets. These combine to potentially produce a short-term capital gains tax cut for many Americans and could result in more significant profits if you’re paying less under the new bracket layout. Investors in the top income tax bracket pay long-term capital gains rates that are lower than their income tax rates. That’s why some very wealthy Americans don’t pay as much in taxes as you might expect.
Dave Barry stated: “It’s income tax time again, Americans: time to gather up those receipts, get out those tax forms, sharpen up that pencil, and stab yourself in the aorta.” Regardless of the new tax reform, if you decide you want to sell your investments and capitalize on an increase in value — the IRS will have something to say about it and I know that few people like to face a large tax bill come April of each year.
Let’s look at an effective strategy so that when life gives you lemons — in the form of taxes — you will ask for sugar and water as well because you know of an innovative way to lower your potential tax liability and increase the after-tax value of your portfolio.
Tax Loss Harvesting
Tax loss harvesting is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” this loss, investors can offset taxable gains in other areas of their portfolio. This is since one can write off the losses when depreciated assets are sold thus canceling out some or all the capital gains on appreciated assets. The sold security can then be replaced by a similar one to maintain an optimal asset allocation as well as expected returns. This can be an effective way to avoid paying capital gains taxes by selling unprofitable investments to offset the capital gains realized from selling profitable investments.
Consider the example of a non-qualified brokerage account where an investor places $100,000 in each of two securities at the beginning of a given year. One will be a winner and the other a loser. At year-end, the winner has increased in value by 20% to $120,000. If the investor chose to sell that security, he or she would be subject to taxes on the $20,000 of gains earned during that year. If his or her tax rate was 35%, $13,000 would make its way to the investor’s pocket while $7000 would be heading towards Uncle Sam’s pocket.
If the other investment lost 10% and declined in value to $90,000 and the investor chose to sell that security as well, the capital loss would be $10,000. This loss can be used to offset part of the $20,000 gain from the winner. In this example, the investor now has only $10,000 in capital gains for the year rather than the original $20,000. The benefit is that the new tax burden is only $3,500 rather than the original $7,000 owed if the lemon had not been sold. Not only has the investor generated a positive return on the original portfolio, but the additional $3,500 saved from tax-loss harvesting can be reinvested back into the markets rather than used to pay taxes.
Furthermore, the current tax rules allow you to use capital losses to offset an unlimited amount of capital gains. If you have any capital losses left over after entirely offsetting your capital gains, then you can apply up to $3,000 of those remaining losses against other types of income, including wages and salaries. Harvested losses can also be carried forward indefinitely to offset future gains or income.
Adhering to the Wash-Sale Rule
Harvesting losses can be a very beneficial strategy, but proper execution is no easy task. The IRS won’t allow you to sell an investment at a loss and then immediately repurchase it back and still claim the loss. If you buy the same holding or any holding the IRS considers “substantially identical” within 30 days before or after you sold at a loss, the loss will be disallowed as it would be considered a “wash-sale.” For example, selling an exchange-traded fund (ETF) or mutual fund that tracks the S&P 500 and buying another from a different provider that also tracks the S&P 500 would likely violate the wash-sale rule as the two funds are almost identical.
In the previous example, the investor succeeded in eliminating current tax liability by selling the loser. The challenge is that he or she also eliminated market exposure because both securities were sold. What if the investor wanted to harvest losses but remain invested in the markets?
An effective way to satisfy this rule is to replace individual stocks, ETFs or mutual funds with others that display similar characteristics to maintain exposure. An example would be selling the stock from one large automobile manufacturer and using the proceeds to buy stock in another large automobile manufacturer, with the expectation that these securities will continue to track each other closely. Selling an ETF that tracks the S&P 500 and buying another that tracks a different yet similar index, such as the Russell 1000, would not violate the wash-sale rule even though both provide exposure to large-cap U.S. stocks.
It’s not about how much money you make. It’s about how much money you keep. By implementing strategies to decrease your taxes, you’ll have more money for your financial future and increase the chances of living the life you have always imagined.
David Rosell is president of Rosell Wealth Management in Bend. rosellwealthmanagement.com. He is the author of Failure is Not an Option- Creating Certainty in the Uncertainty of Retirement and his latest book Keep Climbing — A Millennial’s Guide to Financial Planning. Ask for David’s book at Newport Market, Sintra Restaurant, Bluebird Coffee Shop, Dudley’s Bookshop, Roundabout Books, Sunriver Resort, Amazon.com or Barnes & Noble.
Any tax information is of a general nature, please consult a professional tax advisor to discuss your unique situation. Investment advisory services offered through Valmark Advisers, Inc. an SEC Registered Investment Advisor Securities offered through Valmark Securities, Inc. Member FINRA, SIPC 130 Springside Drive, Ste. 300 Akron, Ohio 44333-2431. 800-765-5201. Rosell Wealth Management is a separate entity from Valmark Securities, Inc. and Valmark Advisers, Inc.
