[Editor's Note: This is a guest post by Glenn Frank CPA/PFS, M.S. Taxation, who is a fee-only financial advisor with Frank Advising and the director of investment strategy at Lexington Wealth Management. Although this post is not a paid or sponsored post, his firm is a paying sponsor of the newsletter and an advertiser on the site. Like every other post on this blog, this one is for educational purposes and does not constitute tax, legal, or accounting advice.]
From the pedestrian to the enlightened, this post should lend insight into one of the few areas where you actually have control in our new American Taxpayer “Relief” Act environment.
“The hardest thing in the world to understand is the income tax.”
-Albert Einstein
Professor Glenn Frank
Accordingly, do your best to understand tax laws – have them work for you whenever possible. I believe you can minimize portfolio taxes without compromising the essence of your 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 and then with proper planning, tax rates should be far less than the marginal rate on your earned income.
If you already know the basics, feel free to skip this next section. Also, keep in mind that this post will ignore state taxes, which could impact decision. For example, you may be moving to or from a no capital gains tax state such as AK,FL,NV,NH,SD,TN,TX,WA,WY. If you do need to pay state taxes, the payment date can be critical. Also, if you owe alternative minimum tax (i.e. are taxed under the AMT system) in the year paid, there is no federal income tax savings due for state income taxes paid as that deduction is disallowed under the AMT.
Schedule D Netting Process
Top half of Schedule D nets short-term (1 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 + capital gain distributions from mutual funds against long-term realized losses/long-term capital loss carryovers from the prior year.
There are three possible outcomes from Schedule D:
- Net short and net long term gains – short taxed at your highest marginal tax rate and the long taxed at your capital gains rate (0%,15%,20%,23.8%);
- Net short-term and net long-term losses – deduct up to $3,000 against other income and carry forward excess to following year.
- Net short is different than net long so they net against each other to produce an overall net gain or net loss – if a net gain taxed per outcome 1, if a net loss taxed per outcome 2. For example, a net short term capital loss of $7,000 and net long-term capital gain of $16,000 will equal a net long-term capital gain of $9,000 which is subject to your long-term capital gains rate.
Schedule D Planning Points
# 1 Harvest Your Losses
Generally you should harvest losses while they exist, using them as a “get out of tax jail free” card to be played later at your discretion. You can effectively maintain positions with tax swaps such as ETFs in the same sector [or a similar, but different, broad-based index fund invested in the same asset class-ed], or simply wait 30 days to buy the investment back to avoid the IRS calling it a “wash sale.”
# 2 Avoid Short-term Gains
Avoid the higher short term capital gains tax [equivalent to your regular tax rate-ed] on significant net short-term gains by waiting one year from the date of purchase.
# 3 Make Appropriate Decisions Regarding Long-term Gains
Despite the loss harvesting etc, you may still be faced with a significant gain. Consider the following questions when deciding whether or not to realize the gain:
A) Would you sell were it not for the tax?
If the answer is yes – realize the gains tax is probably an eventuality and by paying the taxes now you have mitigated risk. Note that the time value of money of paying taxes now versus later (say less than 5 years) is probably minimal when compared to the risk associated with holding the position.
B) What is the opportunity cost?
What might the replacement investment earn? It is tough to pay taxes when you are not sure if the new investment will earn more than what was sold. Remember to factor in volatility reduction into your decision; geometric compounding trumps arithmetic compounding! For example you might replace a single stock in the S&P with an S&P ETF. Presumably the magnitude of loss years for the ETF would be much smaller, creating a compounding advantage in addition to eliminating the single stock risk.
C) Does it really make sense to spread out the taxes over multiple years?
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 one large check this year. However, if the goal is to reduce risk, why wait? Yes you are effectively dollar cost averaging out of the position but at what cost? Prudence might suggest selling now and having the strength to stop following the stock price! [Consider that the total tax bill may be higher by selling the asset over multiple years or vice versa- run the numbers to be sure-ed]
D) Is it possible to shift gains to lower bracket years?
For example, if you file Married Filing Jointly and have an adjusted gross income (AGI) of $425,000, then your capital gains rate is 23.8%. If your AGI were under $250,000, that rate would be just 15%. How long would you need to wait to save 8.8% on the gains and how much risk does waiting entail [gains could be lost, tax rates could change, income could change etc-ed] Conversely, your 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 position with new higher basis since there are no “wash sale” rules for gains. Be sure to consider the time value of money when accelerating taxes.
E) Is it possible to transfer gains to family members with a lower bracket?
Consider using your annual gift tax exemption to give appreciated investments to another family member (remembering that children under 24 may be subject to the kiddie tax.) For example, consider a stock purchased for $10,000 that is now worth $19,000. If sold by the parent, the tax due would be $2,100 (23.8% x $9,000 + state). If gifted to a single child whose taxable income, including $9,000 gain was less than $37,000, you would save the full $2,100 as the child has a 0% capital gains rate. Keep in mind that gifts need to be actual gifts. A coincidental gift backd to you would be frowned upon by the IRS.
[Editor's Note: I added F, as I thought it was an important addition to the list.]
F) Can you wait until you die to sell this investment?
Your heirs receive a step-up in basis upon your death. It would probably be a mistake for a 95 year old in poor health to sell investments with low basis in most situations.
Portfolio Construction Issues
Aside from planning your tax bill each year, capital gain taxation laws also can affect the construction of your portfolio.
Capital Loss Carryovers
WCI has wisely concluded that for many investors, Bonds Go In Taxable. One of the assumptions used in his post may not apply to you – such as ongoing taxation on capital gains. For example if you have significant loss carryovers, consider holding equities in your taxable accounts to utilize the losses (which can not go to your heirs). The presumption here is that equities are more likely to generate gains than bonds. To keep your overall risk profile intact you may then need to sell muni bonds in taxable and flip equities for bonds in your retirement accounts.
Note that with capital loss carryovers, the “tax price” associated with active managers in a taxable account will not be as great. Any long-term capital gain distributions will be offset by the loss carryovers. Note however that short-term capital gain distributions come out as ordinary income and cannot be offset by loss carryovers. If you are going to use actively managed funds, and do not have significant capital loss carryovers, it may be best to hold those funds in retirement accounts. Not only are capital gain distributions out of your control, but if you are able to pick the next Buffett, you may find yourself with a difficult decision if your manager leaves–you must either pay a significant tax or live with his replacement. [Yet another issue index fund investors don't have to worry about-ed.]
Rebalancing
Rebalancing portfolios (selling winners, buying losers) may increase your tax bill. Even if using tax efficient investments (most ETFs, ETNs, index funds, DFA funds etc) in taxable accounts there may come a time to rebalance/reduce risk. It is best to do your rebalancing in tax-protected accounts. [This is also a good reason not to reinvest fund distributions in your taxable accounts- those distributions along with new contributions can be used for rebalancing. Also remember that the literature on rebalancing shows it has a rather small effect, and shouldn't be done more often than once a year to take advantage of momentum effects. In fact, rebalancing every 2-3 years may be optimal-ed]
Variable Annuity
If the majority of your investments are in a taxable account you might consider the purchase of a low-cost variable annuity. The annuity could be used for rebalancing purposes as noted above. Additionally with the absence of retirement accounts, you might find that the annual tax burden on ordinary income and/or capital gains etc generated from your portfolio is too onerous. Note there will be additional costs associated with the VA, so the question to ask yourself is “How much am I willing to pay in fees to save on some taxes?” Additionally the VA needs to fit into your plans -perhaps the ability to defer taxation far beyond 70.5 is appealing [or perhaps your state offers significant asset protection to annuities-ed.]
From my experience Vanguard is an excellent choice for VAs, or if their 16 sub account options are too limited for you, consider Jefferson National which has comparable [or much lower, depending on the amount of assets-ed] costs to Vanguard and many more investment options, including Vanguard, Pimco and DFA. Note that Jefferson National VAs are available directly to individuals but only marketed to fee-only advisors.
Family Transfers
When giving money to family members, keep in mind the tax rules on transfers. If you give shares with a gain to a family member, the family members inherits the basis and thus the gain. But if the investment has a loss, that loss does not carry over to the recipient. So investments with a loss should be sold prior to gifting. [If transaction costs are minimal, losses should almost always be realized as soon as possible, before they go away, through tax loss harvesting-ed.] As mentioned above, if there is a gain, it is best to have it transfer at death to take advantage of the step-up in basis to fair market value on the date of death (or the 6 month alternate valuation date.) The elderly should preferentially spend high basis assets, all else being equal.
What do you think? Do you tax loss harvest? Have you ever purposely harvested a gain/accelerated tax to save money? Comment below!
This was a good article, thanks. Some unrelated question. President yesterday in his state of union address, talked about increasing taxes:
1) The tax plan would raise the top capital gains tax rate to 28 percent, from 23.8 percent.
2) It would also remove what amounts to a tax break for wealthy people who can afford to hold on to their investments until death. (step us basis)
3) Capping retirement accounts at 3.4 Million
How does one prepares for future when so many variables may change? Just take todays time line and freeze and do little bit of this and little bit of that?
First, the president is so serious about getting these tax increases that instead of spending the next week or two working on Congress he’s going to India. The idea that an increase in capital gains rates is going to happen during the next two years with Republicans controlling not one but both houses of Congress seems unlikely to me.
Second, it’s only on a taxable income over $500K. That’s well less than 1% of Americans and perhaps only 10% of doctors unless married to spouse making a lot too.
Third, it’s not that big of an increase, only 4.2% on a tax that the investor has some control over. You still don’t pay it on shares when you die (unless they change the step-up in basis) or on shares you donate.
Fourth, most docs won’t have $3.4 Million in retirement accounts at retirement or at death. Some will. I might. But what does that mean really? Does that mean $3.4 Million in contributions? Or that once it grows to $3.4 Million you can’t contribute more? Or that once it grows to $3.4 Million you have to take out the amount over that? The devil is in the details. Doesn’t matter anyway, because it isn’t going to pass. The Bogleheads don’t even allow you to discuss proposed tax changes until they become law. There’s a good reason- because most of these proposals never do. Last year Obama wanted to get rid of PSLF above $40 or $50K. Obviously that didn’t happen either.
How do you prepare? You don’t. When changes happen, you change your plan. You try to build some flexibility and diversification into your plan. Some Roth, some tax-deferred, maybe some taxable etc. Then you roll with the punches like you always have.
I was more worried about the 529 college plan changes. But once again, it’s not worth stressing about until it happens. Like the stock market, swings this way and that, but I just keep plugging along.
I could not believe Obama wanted to tax 529 growth. That is just wrong. It will prevent people to put money away for childrens education.
Are short term gains offset by long term losses? For eg. lets say I buy Apple stock and sell it for profit after 5 months, and I had Google that I sold for loss after a year. Will my short term gains be offset by long term losses?
Yes, they are. If it is net long term loss, you get to deduct $3K from your regular income. If it is net short term gain, you pay at your regular income tax rates.
Those short term losses that were not used (may have already reached 3000 limit or there were no gains) are carried over to future. Can these capital loss carryovers be used to offset next year short term gains?
Yes.
So I am little confused, the article says :” Note however that short-term capital gain distributions come out as ordinary income and cannot be offset by loss carryovers.” while you said we can. I am little confused.
I’d suggest working through the worksheets/schedules yourself to understand how it works. It’ll cost you a few minutes of time, but will give you a definitive answer for your actual or hypothetical situation.
Be sure to look at the Capital Loss Carryover worksheet on page 11 of the instructions for Schedule D.
Short term losses from last year can definitely be carried over and used against short term gains from this year. We’ll have to ask Professor Frank (perhaps he hasn’t noticed this post was finally published) what he meant by that sentence, but I think he’s saying you can’t use a carried over long-term loss to offset a current short term gain. I don’t even think that’s true though after looking at that worksheet.
Why not come up with a hypothetic situation, run it through the worksheets, and see what pops out? That ought to answer your question definitively. I’ve emailed Professor Frank for clarification.
Hi -this is professor Frank – note the following instructions per IRS for form 1099 DIV
Box 1a. Total Ordinary Dividends
Enter dividends, including dividends from money market funds, net short-term capital gains from mutual funds, and other distributions on stock. Include reinvested dividends and section 404(k) dividends paid directly from the corporation.
accordingly these short term capital gains never make their way to Schedule D, so there is no opportunity to offset with capital losses
1099DIV only has a box for long-term capital gain distributions
many investors and advisors are unaware of this seemingly unfair rule
Thats what I was thinking that you meant Ordinary Dividends will not be offset by carryover losses.
But short term capital gains from the sale of stock by an individual (not a fund) do make their way onto Schedule D, no?
yes
Good article. Since I am still new to the taxable account for investing, and have thankfully not had to encounter a big bear market yet, I am interested to know how long one can “carry over” tax losses beyond 3,000.
If one has a taxable account of 1 million dollars and its value decreases to 500,000 as it would have in 2008, you will inevitably have some big losses.
Can I keep carrying these over every year until gains have made up the difference, or is there a time limit on holding losses?
Thanks,
till your death and after that step up basis unless congress acts on Obama plans
You can carry them over indefinitely. Many wealthy folks who tax loss harvested diligently in 2008 have enough losses to take $3K off their taxable income for the rest of their lives, plus enough to cover many future capital gains.
Thanks guys!
For those that make charitable donations, it’s worth mentioning the significant tax benefit of donating taxable account appreciated assets.
WCI, I was just wondering what your thoughts are on Betterment (and similar products). The short pitch for these products is that the company does all of the things listed above at a very minimal fee (don’t quote me but around 30-40 basis points) that is more than made up for by tax savings. I am nowhere close to the point where I need to worry about this as a resident, who cannot even max out my retirement accounts, but I thought it would be worth asking for my future self…
I was going to bring up Betterment myself (I have a suggested guest post somewhere in WCI’s queue versus trash bin at this point).
Here are the relevant facts:
1) Variable but low fees. Annual fees are 0.35% or $3/month for balances under $10k; 0.25% if total holdings $10-50k, 0.15% if total holdings over $50k. (It’s not a tiered system, so if you have $50,001 it’s all assessed at 0.15%, if that makes sense.)
2) This fee is all you pay. You don’t pay separate fees for their underlying funds in which they invest.
3) They have an automated tax loss harvesting algorithm that they claim works better (and is infinitely less cumbersome) than manual methods. They call it TLH+. Here’s their white paper on it:
https://www.betterment.com/resources/research/tax-loss-harvesting-white-paper/
4) TLH+ is offered only if you have $50k invested. By its nature it only applies to taxable accounts, trivially, which is relevant because Betterment will also manage your traditional or Roth IRAs for you if you want.
5) If you use their TLH+ product and don’t cede control of your tax-deferred accounts then make sure to not invest in the same funds in your tax-deferred holdings, else you’ll get clobbered with a wash sale violation by the IRS, negating your benefits. The easiest way to accomplish this is to stick to target date funds in your tax-deferred account.
I think it’s a fantastic idea myself, and have put my money where my mouth is, establishing and funding a taxable Betterment investment account to use towards a house down payment/closing costs in about 18 months. I’m not at $50k in yet so can’t do tax loss harvesting, but I’ll hit that during the year and hope to harvest at least $3k in losses.
Also consider that TLH only pushes your taxes to a later date, it doesnt save you taxes unless you die and there is step up basis.
It decreases your cost basis, for eg you invest 100K and TLH 20K cause investment down to 80K. Lets say in future you sell it at 110K, now you have to pay taxes on 110-80 = 30K, instead of 110-100 = 10K
If you already have a rental property/depreciation or other passive losses and you are already maxing out 3000 allowed, TLH will only add to carry over losses instead of decreasing your taxable income.
Also I heard Schwab is coming out their TLH.
All true, but a deferred tax can be pretty valuable. Plus you might be in a lower bracket, die, give it to charity etc etc etc.
You indeed lower your basis, but you’ll be paying long-term capital gains rates when you eventually sell 1+ years forward, and you’ll have gained (original price – lower basis price) * (standard income marginal rate) in the interval.
Toshi I would like to know how this formula works. With TLH you only delay taxes to future. And you are allowed to only deduct 3000 a year at your marginal tax rate. For me, my rental property gives me that 3000 a year tax break or what ever bad investments I had sold and already have carryover for a lot of years.
Dont get me wrong, TLH works for people who dont have 3000 a year of passive losses, or who wants to pass on their appreciated shares to charity or family. (That is you are not planning on using your money) Anyway chances of TLH decreases as your old money grows but as they say never say never, god only knows what will happen in future.
There is benefit to delaying the paying of taxes as well. Plus, always the chance you won’t pay them at all (charity, death, etc.)
The formula only works if you hold the investment for at least N years such that N * $3000 >= reduction in basis that you realized.
Example with round numbers, 33% ordinary income marginal rate (which implies 15% LTCG rate):
$100k initial investment. Huge drop +/- you harvesting a $30k loss. Hold onto it for 10 years and do nothing else in interval, then sell at $120k.
Scenario 1, no tax loss harvesting: You pay $20k * 15% LTCG rate in taxes: Negative $3k (in the sense that you pay the government).
Scenario 2, tax loss harvesting: You pay $50k * 15% LTCG rate in taxes, but you offset this with $30k * 33% ordinary income rate in reduced ordinary income. -$7,500 + $10,000 == net positive $2.5k.
In other words, in this scenario, tax loss harvesting gained you $5,500 + the value inherent in getting the money back up front, as it were.
What if you already have enough losses to last you 20-30 years, will TLH still make you money? That is you are not using the 3000 a year @ your marginal tax rate as you have enough losses at other places, how will TLH help then?
Probably not going to help much. But it also isn’t going to hurt much. It’s not like it takes a lot of effort or money to do.
coincidently we covered Betterment last night in class – I would agree with Jim’s positive commentary -as Robo advisors go they are near the top -they will get even “better” over time once they can integrate multiple accounts at once (I believe they treat IRA/ taxable/Roth as separate accounts by individually diversifying them as opposed to locating investments in the total portfolio optimally from a tax perspective – you will find the roughly same investments in each account – this may not be that material) also the integration of financial planning (what real rate of return does the investor need + how much risk can they stomach) is lacking -per a recent discussion, they are making progress on both fronts and will roll out improvements before long- – all told for what you pay you get a lot – might also consider a target date fund from Vanguard -it is interesting if you look at a competing Robo -Wealthfront they dismiss (inaccurately) in their FAQs the use of Vanguard’s target date funds apparently realizing a worthy competitor – it is exciting times in our industry as we find more and more technology capturing “advisor wisdom” and then being passed along to individual investors in a cost effective, minimal conflicts of interest fashion
Betterment varies the investment mix depending on whether it’s dealing with a tax-deferred or taxable account. See here for instance:
https://www.betterment.com/portfolio/
Flip the widget between Taxable and IRA and you’ll see that the third bond listing both changes in allocation but changes from muni bonds in the taxable account to “high-quality bonds” in the tax-deferred.
While that’s better than nothing, I think what Prof. Frank is saying is that instead of having basically the same allocation in each account (but with munis in taxable) a wise individual investor or advisor might instead determine that he should have all his bonds in taxable and none in the IRA. Betterment doesn’t decide that automatically.
Dr Khan,
You are forgetting donating appreciated shares to charity. If you already are donating to charity, then once you hold any fund one year you can donate away that capital gain, take the full market value as a tax deduction, and then immediately repurchase what you donated. There is no “donated capital gain wash sale” rules to worty about.
Only munis in taxable acct for obvious reasons
Opportunity cost is everything when considering closing out positions to save money on taxes. Good luck to all of those trying to make this decision!
Hi, I have a quick question on rules for charitable donations from a taxable account. My understanding is that the stock (or mutual fund) needs to have been owned for a year in order to donate the appreciated shares. Otherwise, if it’s owned less than a year, then the donation first counts as a sale with realized capital gains that become taxable for the donor. What happens when the stock has been owned for over one year, however, one donates the most appreciated shares which were purchased less than a full year ago (in order to donate the shares with lowest basis and the most unrealized capital gains)? Does this still count as donating stock, or as selling it and realizing the capital gains? Thank you!
Less than a year it doesn’t count, even if you own something else that you’ve had for more than a year.
Question regarding short term and long term capital gains. I know short term gain is taxed as ordinary income and long term gain is taxed at lower rate. On schedule D, line 7 is net short term capital gain and line 15 is net long term capital gain. I have gains for both line 7 and 15. Then line 16 asks to combine line 7 and 15 and report it on 1040.
So then I am paying the same tax rate for both short and long term capital gain as ordinary income tax. How do you separate short term and long term gain so that they are taxed at different rates?
I think it’s in a worksheet where that is adjusted. Are you doing it by hand or using software?