Tax Loss Harvesting
As many have heard by now, various news sources released a look at information contained within President Trump’s tax returns. Let’s pause for a second. Yes, even after the very first sentence.
I’m putting all political inclinations and postures aside in this column. I’m making no claims about the validity or credibility of anything that has been in the news about the President’s taxes, nor will I pretend to know anything about his complex tax circumstances and the issues around it.
But what I will do is take a moment to shine the light on something that many people overlook in their wealth planning. It was claimed that the President paid only $750 in income tax and there’s no doubt that people spit their drinks out when learning that. Again, assuming all details are correct, and his returns were properly filed, this points to a strategy called Tax Loss Harvesting.
Tax Avoidance versus Tax Evasion
First, there’s an important point to make about tax loss harvesting: tax avoidance is not tax evasion. The latter illegal, while the former should be something your financial professionals should be talking to you about. Tax loss harvesting is a powerful technique implemented in tax-managing investments in a manner that minimizes someone’s tax burdens.
It is generally possible to offset capital gains with capital losses and carry forward any losses you’ve not used. In the President’s case, having losses in investment holdings, specifically real estate in his case, allowed him to obtain credits on his taxes so that he could reduce his tax liability. Down to as low as $750? Like I said, I’m not here to be the judge, but it’s technically possible.
Who, What, and Where
Before going on, it’s important to make the distinction about what types of investments you can apply this strategy to. You can tax-manage taxable accounts (Individual, Joint, Trusts, Custodial, etc.), where you cannot in retirement accounts. You can’t tax loss harvest tax-deferred accounts (whew, that’s a mouthful). Retirement accounts (IRAs, TSP, 401Ks, 403Bs, etc.) are “tax-deferred”, so you already get your gift there. You can do better tax-planning around distributions, Roth conversions, inherited IRAs, etc., and further reduce your tax liability, but that’s another topic.
Another important detail to discuss is the types of capital gains and losses. A short-term gain or loss is “realized” (sale to make liquid) from an investment held for one year or less before being sold, where a long-term gain or loss is one realized after a holding period of over a year.
Short-term gains, like retirement-plan distributions, are taxed at ordinary income tax rates (ouch), just like your salary is taxed. Depending on where you live and your income, you may be subject to as much as a 40%-45% tax on short-term capital gains between state and federal taxes. Long-term gains are taxed at 0%, 15%, and 20%, depending on your income levels. Yes, 0% is for real – more on that later.
Tax-Managing Portfolios IS Financial Planning
So why would anyone sell an investment that’s low in value? Shouldn’t you wait until the price rises since it’s potentially just volatility moving the price (if it’s a good investment to start with)? My favorite answer to financial questions: it depends.
Let’s say you need to generate income from your portfolio to meet your living expenses, or less commonly, you have an appreciated investment that you’re looking to diversifying away from, such as all of those Apple shares you decided to buy 20 years ago. If your portfolio is being properly tax-managed, you can offset those gains by also realizing some losses, and it’s possible to effectively net $0 after this and pay no taxes, even though you made money on your sale.
Further, in years where your taxable income is significantly lower, like perhaps in a year where you take a hiatus between job changes, you could effectively realize gains in your portfolio and pay NO capital gains taxes because your income was low enough for that year. These moments in your life tend to be few and far between, so if you have this opportunity and take advantage of it properly, you could save yourself tens of thousands of dollars in taxes. In my time helping people manage their wealth, these moments are some of the most exciting – making money and paying no taxes, how great is that! We can help create tax efficiency on a portfolio to add additional value above and beyond the growth on an account, and the best part is that it’s all measurable so you can see how much you’re saving.
What about short-term? Remember how it’s taxed at ordinary income levels and how that hurts my heart a little bit? You can offset those gains with short-term losses by properly managing your portfolio rebalances. Short-term losses are generally highly valuable because they are offsetting gains that are being taxed at the highest rate. Think about how much someone can save in taxes if done correctly. If you have extra short-term losses, you can effectively reduce all of your short-term gain, saving yourself a third or more in taxes, depending on your income tax bracket.
Here’s where the rubber meets the road. Short-term losses should be considered like a mini pot of gold. Not only can you offset short-term gains and save yourself nearly a third or more in taxes (depending on your income tax bracket and state you live in), but you can continue to offset long-term capital gains taxes too, effectively paying NO capital gains taxes, and on top of that, $3,000 of carried over losses can be applied to your ordinary income like your salary, which is the most highly taxed wealth you have. This is a triple whammy tax saving if done properly.
If that weren’t enough, you can carry forward any remaining losses for future years. This detail is likely how real estate investors like the President is able take down their taxable income to such low levels. Since ordinary income is taxed at a much higher rate than capital gains, this carryover proves to be extremely valuable, especially if this technique is applied year after year.
How and Why
So how do you keep track of all of this? Shouldn’t you be avoiding that much in losses in your portfolio anyway? As a whole, yes, but any normal portfolio will go up and down as volatility moves the prices of your investments. If your portfolio is intentionally shaving off bits of losses here and there and accumulating it so that it can be used when rebalancing your portfolio and realizing gains, you can grow your investments and reduce your tax liability nearly every time. This really adds up over time if done effectively. There are investments that go in and out of style and favor over time, and those can become great generators of this mini pot of gold.
These micro-losses which can be harvested and used to protect our gains are one of the embedded gifts in the cycles of volatility of which the markets are made. Taxable portfolios that are being rebalanced without tax-management consideration are giving up dollars toward taxes without people even understanding that it’s happening. I’ve seen this time and time again when we develop a financial plan for someone. Tax-managing a taxable investment account takes deliberate effort and the creation of tax liabilities is a common negative side effect of accounts that “auto-rebalance”.
Tax-Efficient Estate Planning
Another element of tax-managing your investments is a consideration for specially designed estate planning. When someone inherits an asset, the tax-basis in that asset is “stepped up” to what it’s worth when you inherit it. If you sell it that same day, you pay no capital gains taxes. How can you apply this? By properly tax-managing your wealth, you can ensure you’re supplementing your own needs while living with higher-basis assets and leaving your lower-basis to your heirs, effectively “resetting” the point in which taxes are calculated. If you have assets that are ear-marked for your heirs, tax-management on those assets should be a top priority so that you can maximize your legacy to your heirs, whether family or philanthropic.
The Wash-Sale rule states that your tax write-offs are disallowed if you repurchase the same investment, contract for the option to buy the investment, or a substantially identical investment within 30 days after the sale of your loss-generating transaction. It’s a relatively easy rule to follow, but this generally becomes a surprise problem for folks in the private sector who get compensated with Employee Stock Purchase Plans (ESPP). This won’t really be a surprise for federal employees unless your spouse falls into that category or you break the rule. Either way, you need to be careful and have parameters measured and set in place to ensure this rule isn’t broken.
We all know that taxes fund the country that we love and that it’s a necessary part of our society. We benefit from the gifts of road maintenance, public schools, emergency services, etc. But that doesn’t keep us from being able to benefit from all of the techniques and tactics that are available in our toolbox. We all work hard and want to keep as much of what we earn as we can, and ensuring that your portfolio is tax-efficient is a critical part of your financial plan. The ethics of not paying any taxes are another subject for discussion. Supreme Court Justice Learned Hand said, “…anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes….for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions.”