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“The hardest thing in the world to understand is the income tax.”
-Albert Einstein
This article will lend insight into one of the few areas that investors actually can control in our new American Taxpayer “Relief” Act environment.
Accordingly, do your best to understand tax laws; have them work for your clients whenever possible. You can minimize portfolio taxes without compromising the essence of an investment strategy.
Unlike most forms of income, the timing of taxation on capital transactions is largely up to the investor. Regardless of economic gain, taxes are not incurred until investments are sold. With proper planning, tax rates should be far less than the marginal rate on ordinary income.
This article ignores state taxes, which could impact decisions. For example a client may be moving to or from a no capital gains tax state such as AK,FL,NV,NH,SD,TN,TX,WA and WY. If clients need to pay state taxes, the payment date can be critical. If included in the alternative-minimum tax (AMT) in the year paid, then no federal tax savings may result, as state taxes are a preference item.
The schedule D netting process
The top half of schedule D nets short-term (one year or less) realized gains against short-term realized losses/short-term loss carryovers from the prior year.
The lower half of Schedule D nets long-term realized gains plus capital gain distributions from mutual funds against long-term realized losses/long-term capital loss carryovers from the prior year.
Here are the possible outcomes:
A) Net short and net long term gains – short-term gains are taxed at highest marginal tax rate and the long-term gains are taxed at capital gains rate (one of four different rates, depending on income: 0%, 15%, 20% or 23.8%);
B) Net short-term and net long-term losses – you can deduct up to $3,000 in losses against other income and carry forward any excess to the following year.
C) Net short-term losses or gains are different from net long-term losses or gains and produce an overall net gain or net loss – if a net gain, see A. If a net loss, see B. As an example, a net short-term capital loss of $7,000 and net long-term capital gain of $16,000 would yield a net long-term capital gain of $9,000 which is subject to the long-term capital gains rate.
The schedule D planning points
Here are the various actions you can take:
Harvest losses
Generally one should harvest losses while they exist, using losses as a “get out of tax jail free” card to be played later at investor’s discretion. If desired, effectively maintain positions via tax swaps. For example, swap position with an ETF in the same sector and swap back, adhering to 30-day wash sale rules.
Avoid short-term gains
Avoid high tax on material net short-term gains by waiting until the one-year purchase anniversary or by harvesting offsetting losses elsewhere in taxable accounts (again navigate wash sale rules per above).
Long-term gains
Despite loss harvesting, the investor may still be faced with a significant gain. Some subtleties to consider when deciding whether or not to sell:
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Would they sell were it not for the tax? If so, accept that the capital gains tax is an eventuality and by paying the taxes now they have mitigated risk. The time value of money used to pay taxes now versus later (say less than five years) is de minimis when compared to the risk associated with holding the position.
What is the opportunity cost? What might the replacement investment earn? Paying taxes without the assurance of higher returns on the new investment is difficult. Remember to factor in volatility reduction into the decision – geometric compounding trumps arithmetic compounding! For example you might replace a single stock in the S&P with an S&P fund. Presumably the magnitude of loss years for the fund would be much smaller, creating a compounding advantage in addition to eliminating the single stock risk. A 100% gain followed by a 50% loss has an average return of 25% and a 0% compounded return.
Selling over a number of years to spread out the tax pain has an emotional appeal. Writing smaller checks over the next four years may be more palatable than writing one large check in April. If the goal however is to reduce risk, why wait? Yes, you are effectively dollar-cost averaging out of the position but at what cost? Prudence suggests selling now, assuming client has the strength to stop following the stock price!
Shift gains to lower bracket years
If married filing jointly, with adjusted gross income (AGI) over $425,000 the capital gains rate is 23.8% if AGI is under $250,000, it is 15%. If you are subject to the high rate now, how long do you need to wait to save 8.8% of gain in this example? How much risk does that entail? Conversely the bracket may be lower now than in the future. So harvest gains currently, paying tax now at perhaps 15% versus later at a higher rate. Unlike losses, you can immediately buy back the position with a new higher basis. There are no “wash sale” rules for gains! Additional questions include: What is time value of money used to accelerate tax payments? Would heirs ultimately receive a step-up in basis on the position?
Transfer gains to lower bracket family members
Note that children under 24 may be subject to “kiddie tax.” A stock originally purchased for $10,000 is now worth $19,000. If sold by a parent, he or she might pay $2,100 (23.8% x $9,000 + state taxes). If gifted to a non-kiddie tax single child whose taxable income, including $9,000 gain is less than $37,000, you save a full $2,100 as the child has a 0% capital gains rate. Such a transaction needs to be an actual “gift.” A coincidental gift back to parent would be frowned upon by the IRS.
Gift gains to charity
If in the example above the stock was gifted to a qualified charity instead of a child, the couple would still avoid the $2,100 tax and the deduction might save as much as $7,500 ($19,000 X 39.6%) as an itemized deduction. Consider donor advised funds. Charitable remainder trusts may be appropriate if the amounts involved are large enough to justify the cost and complexity.
Capital-loss carryovers
If one has significant loss carryovers, consider holding equities in taxable accounts to utilize the losses, which cannot go to heirs. The presumption here is that equities are more likely to generate gains than bonds. Keeping one’s overall risk profile in tact may involve selling municipal bonds in taxable accounts and flip equities for bonds in retirement accounts.
With capital-loss carryovers, the “tax price” associated with active managers in a taxable account will not be as great. Long-term capital gain distributions will be offset by the loss carryovers. However, short-term capital gain distributions come out as ordinary income and cannot be offset by loss carryovers.
Rebalancing
Rebalancing portfolios (selling winners, buying losers) may fly in the face of taxes. Even if using tax efficient investments in taxable accounts-- including most ETFs, ETNs, index funds, SMAs and DFA funds -- there may come a time to rebalance or reduce risk. Consider holding the same equity asset classes in retirement accounts as in taxable accounts to rebalance back to targets without incurring gains because there is no tax when investments are sold in retirement accounts.
Variable annuities
If the majority of one’s investments are in a taxable environment, consider the use of a low-cost variable annuity (VA). The annuity could be used for rebalancing purposes as noted above. Additionally in the absence of retirement accounts, the annual tax burden generated from a portfolio may be too onerous if tax inefficient investments are greater than a retirement account has room for). There will be additional costs associated with the VA, so the question is “What price tax deferral?” Additionally the VA needs to fit into the client’s plans -perhaps the ability to defer taxation far beyond age 70.5 is appealing.
From my experience Vanguard is an excellent choice for VAs, or if its 16 sub-account options are too limited, consider Jefferson National, which has comparable costs to Vanguard and many more investment options, including Vanguard, PIMCO and DFA.
Family transfers
If making a lifetime gift at a gain, then the basis will carry over to recipient. If at a loss then there is no carry over therefore the donor should sell the asset and take the loss and gift proceeds.
If there is an estate transfer, then there is a step-up (or step-down) in basis to fair market value on date of death (or six-month alternate valuation date). With these rules in mind, consider not selling or spending low basis holdings for retirement lifestyle.
I hope this article is timely in minimizing your portfolio’s tax burden.
Taxation, legal, financial and other matters referred to on this post are of a general nature only and are based on Glenn Frank’s interpretation of laws existing at the time and should not be relied upon in place of appropriate professional advice. Those laws may change from time to time.
Glenn Frank is the director of investment tax strategy for Lexington Wealth Management in Lexington, MA and was the founding director of the Master of Personal Financial Planning program at Bentley University in Waltham, MA. He is a member of the program’s advisory board and teaches two portfolio construction courses within the program – Portfolio Management and Investment Vehicles. He is also the patent holder on “OptiTax” – a software tool that optimizes the location of investments between taxable and tax-deferred accounts. Glenn has a new practice "Frank Advising," which provides portfolio tax guidance to both individuals and advisors.
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