Taxes assessed against capital gains are the one truly voluntary type of taxation in America. Since you control the timing of asset sales, you’re in charge of determining how much you’ll pay in taxes (within IRS parameters) – and when those taxes will be paid. Make the tax laws work for you, and you’ll minimize portfolio taxes without undermining your investment strategy.
Schedule D Netting
The first half of Schedule D nets realized gains of one year or less against short-term realized losses and loss carryovers from the previous year. The second half of Schedule D nets long-term realized gains plus capital gain distributions from investments against long-term realized losses and long-term capital loss carryovers from the prior year. Short term gains don’t benefit from any special tax rate, and are instead taxed at the same rate as ordinary income. On the other hand, if you hold an asset for over one year, you’ll benefit from a reduced rate of taxation on your profits. If your ordinary tax rate isn’t greater than 15%, you can qualify for zero long-term capital gains tax. For high-income taxpayers, the capital gains tax rate may peel as much as 19.6% off of the ordinary income tax rate.
Filing Schedule D involves three possible outcomes:
- If there are net gains (both short and long-term) the short will be taxed at your highest marginal tax rate, with the long taxed at your capital gains rate.
- If you have losses that are both short and long-term, you can deduct up to $3,000 against other income, carrying forward any excess until next year.
- If the net short is different from the net long they will combine to produce either an overall net gain or loss. A net gain will be taxed per outcome 1, while a net loss is taxed per outcome 2. For example, a net short term capital loss of $10,000 and a net long term capital gain of $15,000 yields a net long-term capital gain of $5,000, and is subject to your long-term capital gains tax rate.
Schedule D Planning
- Avoid Short-Term Gains
Not all capital gains are treated equally, and the tax rate varies considerably between short and long term capital gains. Wait at least a year from the date of purchase to sell your investment, in order to avoid triggering the higher short term capital gains tax rate.
- Harvest Your Losses
You can bolster after-tax stock returns via tax-loss harvesting, and it’s typically wise to harvest losses as they occur. Using investment losses to offset taxable income can lead to incremental tax savings – or a larger refund. You can effectively maintain your investment position using tax swaps to products in the same sector, or just wait a month to repurchase the investment without triggering the wash sale rules.
- Plan For Long-Term Gains
If you’re facing the prospect of taxation on significant investment gains, here’s what you need to consider:
- Should you attempt to transfer your gains to lower tax years?
If you believe that you’ll be in a higher tax bracket in the future, you may wish to harvest your gains today. This means that you may be able to settle your tax obligations now at perhaps 15%, rather than doing so later at a higher rate. Since there are no wash sale rules for gains, you can immediately buy back your position with a new higher basis. On the other hand, if you plan on being in a lower tax bracket in the future, you might want to delay selling until that time.
- Would you sell if it weren’t for the tax?
If you say yes, you should realize that the capital gains tax is likely inevitable – and you can mitigate your risk by paying the taxes now. The time value of money of paying taxes now rather than later is likely to be trivial when compared to the risk associated with holding the position.
- Can you transfer investment gains to family members?
If you don’t want to pay 15% or 20% in capital gains taxes, give your appreciated assets to someone who will be taxed at a lower rate. The IRS permits gifts of up to $13,000 per person, per year, without incurring any gift tax. You may be able to use your annual gift tax exemption to give appreciated investments to another family member. If you do, remember that children under 24 years of age could be subject to the kiddie tax. These dependents have to pay at their parents’ tax rates if they have unearned income from any source – such as capital gains or interest income – that exceeds $2,000. For example, a stock purchased for $10,000 that is presently worth $15,000 would generate a $1,190 tax liability ($5000 x 23.8%) if sold by the parent. Gifting this stock to a single child with a taxable income under $37,000 (including this $5,000 profit) would generate a savings of the entire $1,190, since the child is taxed at a 0% capital gains rate.
- Should you spread your taxes out over multiple years?
An installment sale allows you to spread your income from the sale over a number of years. Your gain is calculated once (gross proceeds minus cost basis minus selling expenses) and is expressed as a gross profit percentage – applied to each payment as it’s received. This can sometimes result in lower total taxes paid, since income is being taxed at potentially lower rates. It may seem more palatable to spread out the tax pain by writing smaller checks over the next four years, rather than one huge check this year. But, if you’re selling to reduce risk, you might be better off selling now rather than trying to dollar cost average your way out of the position. This allows you to minimize big, short-term spikes in income – and therefore taxes – leaving you with more cash in hand to invest.
- Should you attempt to transfer your gains to lower tax years?
Construction Of Your Portfolio
Capital gains tax isn’t merely an issue impacting the very wealthy. Ordinary taxpayers can easily save thousands on capital gains taxes with these strategies. Since capital gain tax rates can be just as high as regular income taxes, it’s worthwhile to explore every possibility for keeping them at a minimum.
Capital Loss Carryovers
Capital gains are reduced by capital losses incurred during the same year. You can use up your capital losses in those years you have capital gains, but you’re only allowed to take $3,000 of net capital losses per year. You do get to carry $3,000 of net capital losses into future tax years. If your portfolio has significant loss carryovers, you may want to keep equities in your taxable accounts in order to utilize those losses, since they can’t go to your heirs. Based on the assumption that equities will likely generate greater gains than bonds, you might want to sell muni bonds in your taxable accounts, while trading equities for bonds in your retirement accounts. The distribution of long-term capital gains can be offset by loss carryovers – while short-term gain distributions are treated as ordinary income – and therefore can’t be offset by loss carryovers. If you invest in actively managed funds, and therefore lack significant capital loss carryovers, you might want to keep these investments in retirement accounts.
If most of your investments are held within a taxable account, you might want to purchase a low-cost variable annuity for assets that throw off ordinary income (interest and ordinary dividends). These are basically mutual funds with an insurance wrapper. Annuities can be used for portfolio rebalancing, tax sheltering of ordinary income and/or capital gains, and enhanced asset protection, depending on your state. Your contributions and earnings grow tax-deferred until you begin withdrawing funds. In certain states, annuities are a shelter from creditors – making them a great savings tool. Keep in mind that once you purchase an annuity, you won’t be allowed to touch those funds until you reach the age of 59 ½, or you’ll pay a 10% penalty. Appreciation in the annuity will be taxed at ordinary rates. There will also be additional costs associated with the variable annuity, with the average investment charging annual fees and potential surrender charges should you decide to end your contract before its term is over.
If you give money to family members, don’t forget about the tax rules on transfers. When you give appreciated shares to a member of your family, he inherits the basis – and thus the gain. However, if there is a loss, this doesn’t transfer to the recipient. As mentioned previously, if there is a gain, it should be transferred at death, if possible, to take advantage of the step-up in basis to fair market value upon the date of death.
Minimizing your tax burden requires a comprehensive financial analysis by investment professionals. At Werba Rubin, we’re committed to helping you achieve your goals by making the most of your financial resources, and that includes avoiding the expense of unnecessary taxes.
All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.
The information herein is general in nature and should not be considered insurance, legal or tax advice. Please consult with an insurance legal or tax professional for additional information on specific situations.
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