[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

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.

Schedule D-page-001Schedule D-page-002There are three possible outcomes from Schedule D:

  1. 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%);
  2. Net short-term and net long-term losses – deduct up to $3,000 against other income and carry forward excess to following year.
  3. 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 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!