By Dr. Leif Dahleen, Columnist
Today, I’d like to explore strategies to avoid taxes on capital gains and dividends. Both of these investment returns come in two flavors. Short-term capital gains and ordinary non-qualified dividends are taxed like income, so it’s awfully difficult to avoid taxes on those.
Long-term capital gains (LTCG), realized when you sell an asset you’ve held for more than a year, and qualified dividends (QD) are a different variety. The tax treatment on them can be much more favorable.
It can also be not so favorable. Typically, even though these taxes are generally lower than income tax, you can expect to pay at least 15%on them, and as much as about 37% if you happen to make millions and live in California. How so?
- 3.8% NIIT tax (a.k.a. ACA surtax) for individuals with AGI of at least $200,000, or couples with an AGI of at least $250,000
- Additional 5% tax for those in the top federal income tax bracket
- State income tax in most states, which runs as high as 13.3%
Although I’m not in the top federal income tax bracket, I pay the 3.8% and a hefty state income tax anytime I realize LTCG or a QD in my taxable account. It’s important to note that you won’t see these taxes in a Roth or tax-deferred account. This Top 5 list applies to a taxable account.
The Top 5 Ways to Pay No Tax On Capital Gains & Dividends
#1 Keep Taxable Income Low (and Be Married)
I’m not trying to say you should let the tax tail wag the dog.
not much of a sled dog
By all means, earn what you can while you’re accumulating wealth, and avoid turnover in your taxable account (buy and hold). The time to keep taxable income low is in retirement. If a substantial portion of your nest egg is in taxable and Roth dollars, you should be able to keep your taxable income far below your annual budget.
In 2018, a couple can have a taxable income of $77,200 and pay no tax on all LTCG and QD. While this may sound low to you, we learned in The Taxman Leaveth how a couple with a well-constructed portfolio can easily spend six figures while keeping taxable income low.
For a single filer, you can only have half the taxable income to be in the 0% LTCG & QD bracket. Keeping taxable income under $37,650 is a big ask for most retired physicians. Love and marriage pays.
#2 Tax Loss Harvest/Tax Gain Harvest
On January 20th, 2016 I made two quick exchanges in my Vanguard taxable account. I sold shares of VFIAX (S&P 500 Index) to buy shares of VTSAX (Total Stock Market). I also sold shares of VTMGX (Developed International index) to buy shares of VFWAX (International Index).
In two minutes, I had a paper loss of about $39,000, but remained invested in assets that correlate very well to my original position.
That $39,000 capital loss can be used to offset future LTCG, or better yet, $3,000 of earned income every year for 13 years. Behold the power of tax loss harvesting.
If you go over by a few hundred dollars, don’t worry. Having a taxable income of $78,000 doesn’t mean you pay 15% on all LTCG & QD, just on the $800 overage.
#3 Donate Appreciated Shares to Charity
You might not be in love with willfully parting with your hard earned money, but trust me, it’s better than option #4. It’s also true that giving, or joyful generosity, is a key contributor to our happiness. When you donate appreciated assets, capital gains taxes aren’t paid by the giver or receiver. Win, win.
Giving stocks or mutual funds directly to a charity can be cumbersome. I advocate the use of a Donor Advised Fund to facilitate the transaction. I’ve had several DAFs, but I prefer Fidelity’s for its low costs and low $50 minimum grant.
#4 Die
That’s right. Buy the farm. Kick the bucket. When assets in a taxable account are passed on to heirs in the next generation, the cost basis is reset to the current value. The assets can then be sold, tax-free. The tax savings can be huge.
For example, if I had been a smart baby and purchased $10,000 of an S&P 500 index fund when I was born in 1975, it would be worth nearly $1 Million today ($953,00 with dividends reinvested as of January 2018).
Selling it today, I would incur over $250,000 in taxes. But if I were to start pushing up daisies, leaving the fund to my children, no tax would be owed, and the cost basis would be reset to the value at the time of my untimely demise (unless the estate is exceedingly large and we’re looking at estate taxes).
A couple caveats. The first index fund wasn’t sold until the year after I was born, when John Bogle of Vanguard fame created the First Index Investment Trust. Also, I don’t recommend death as a tax avoidance strategy, but the knowledge could be helpful in estate planning. Don’t give those highly appreciated assets away while alive. Leave them for your heirs to inherit tax-free.
Interestingly, when passing along to a surviving spouse, the cost-basis is stepped up to the halfway point between the initial cost and the current valuation.
#5 Buy Equities with Low or No Dividend
money away, or keel over. What’s a doc to do while working, saving, and staying alive?
You can do your best to invest in equities that don’t return much to investors beyond growth in the intrinsic value of the stock. Some companies pay no dividends. Warren Buffett’s Berkshire Hathaway is famous for being one of them. Owning BRK stock, you will get all the benefits of the total return, and none of the tax drag that dividend producing assets give you.
Growth stocks are another asset class that tends to offer lower dividends compared to the total market and value stocks. Of course, if growth stocks underperform (see the year 2000), the tax benefit might be outweighed by poor performance.
Are you able to take advantage of any of these? I currently #2,3, and to some extent #5 by sticking with tax-efficient index funds in the taxable account. I look forward to the possibility of #1, and hope to stave off #4 as long as possible. Have you got a #6? Comment below!
#4 “Interestingly, when passing along to a surviving spouse, the cost-basis is stepped up to the halfway point between the initial cost and the current valuation.” So should we retitle all our JTROS funds to half his half hers? Please explain more.
Great question / point, Jenn. That section deserves some clarification.
Jointly held assets are stepped up by half. Assets held by only one spouse for more than a year benefit in a full step up in cost basis when inherited by the surviving spouse.
I suppose the ideal setup would be to transfer all assets in a taxable account to the spouse most likely to die first, but at least a year before death comes. It’s tricky business and could foul up some asset protection if you see some benefit from having assets titled as joint tenants by entirety.
Best,
-PoF
Just to clarify a bit more. If this is important to you, please verify your situation. For instance, if an account is jointly held by husband and wife who are residents of a community property state, there is a full step up basis in the death of one spouse.
Consider if half of the assets are entirely on spouse 1 name and half the assets are entirely in spouse 2 name with the same capital gains embedded in each. Then when spouse 1 dies, their assets get a 100% stepped up basis. So if spouse 2 sells everything, the bottom line is the same as if all the assets had been titled joint. Note this is not true in a community property state.
This post epitomizes why PoF’s website has seen such impressive growth the first 2 years (including being the first to be asked to join the WCI network!). This is probably one of the best financial posts describing a complicated and intimidating topic to most in a distilled and extremely useful manner. I immediately implemented #2, #3, and #5 when I first read the original PoF post soon after I started investing/saving for FI and saved many thousands in taxed. I am planning on converting a small IRA to a Roth this coming year and selling my holdings in munibonds (also tax free federal dividends not capital gains, but with many downsides) as our incomes will be losing a couple zeros much due to starting a practice and travel sabbatical.
Cracks me up. The comment below says this is too basic, yet you describe it as a complicated and intimidating topic.
Completely agree, great into to a complex topic. Made me rethink my current strategy to tax-defer as much as possible. But TLH/TGH seem like potentially more effort than I want to spend.
What are the downsides to Muni bonds? I hold them in taxable currently and I like that they are maintenance-free.
No big downsides, as long as your investment plan calls for you to have bonds in the portfolio.
Too basic learned nothing. Will look into brk stock, been meaning to..
I aim to inform and inspire. You may be among the 5% or fewer who learn nothing from a post like this, but I’m happy to hear you’re inspired to look into Berkshire Hathaway further. Mission accomplished.
The link to the company under #5 above will give you more detailed info, including the many familiar companies BRK partially or fully owns. The stock has performed well since my initial investment in August of 2016 — it’s up 48%.
Cheers!
-PoF
Can’t please all the people all the time unfortunately. We try to have material that is at a basic level, at an intermediate level, and at an advanced level. The more you learn, the less you’ll appreciate the more basic pieces.
I suppose number 6 is something that POF has written about before which is to use the taxable account early on to perform a Roth Ladder Conversion in early retirement while income is low to avoid higher taxes and fees on that. Only have to wait five years to pull it out this way.
This doesn’t save tax from the taxabale account, but does use the taxabale account to save taxes elsewhere.
I’ve always enjoyed this post. I like creative ways to stave off taxes!
I was thinking Roth conversions might be a small part of our plan; that I’d like to be old with 50:50 roth:regular ira funds. Then some article (here probably) got me thinking about RMDs and social security and dang if we won’t be in a real high tax bracket when we hit 70 and have RMDs and SS! So new strategy (perfect timing as we stopped wage income last year) is max out the 25% bracket with conversions, watch nonRoth totals and growth and projected tax laws and likely SS income and consider even bigger Roth cconversions before RMD and SS time. I had always thought ‘what if the tax rates really plummet and you’ve paid 28% to get ROth funds to save 15% in taxes later’, but had overlooked how RMD + SS will already take us into a much higher bracket probably even two up from 25%. So now my strategy is to look at likely RMDs as I decide how much Roth conversion to do.
Via email:
6. Gift highly appreciated stock or mutual fund to your children. They keep your basis and you keep the income off your tax statement and they probably have a lower tax bracket. Don’t have to die to get stepped up basis. Kiddie tax and gifting limits have to be considered but good way to fund some of college expenses or just to provide support or money for them to fund ROTH or other tax beneficial plan that they might not otherwise fund. Beats the heck out of selling stock, triggering various tax issues and giving them after tax cash. Good way to help them understand the value of investing, how to buy sell stock, set up investments, handling investment returns for filing taxes, budgeting a larger amount of money over time for college.
So if you had highly appreciated shares/stock and you gifted them to you child who has a UTMA, and they sold all of the shares, would there be no tax on the appreciation because they have either no income, or their income would be in the 0% LTCG & QD bracket?
That’s entirely possible. But bear in mind it can’t be very much stock before the kiddie tax kicks in.
Correct me if I’m wrong, but my understanding with the new tax reform law is that any unearned income from a minor will be subjected to the trust tax brackets; i.e. any income up to $2550 will be taxed at 10%, $2550-$9150 will be 24%, etc… I believe the old tax law had no taxes due up to $2100 of unearned income, but then anything above was subject to the parent/guardians maximum tax rate. So from now on, one will be paying taxes on any gains from a UTMA?
I think that is wrong. I still think there is a certain amount that is tax-free and a certain amount taxed at 10%. Then the trust brackets are used instead of the parents’ brackets. https://meyersmoney.blog/2018/01/04/kiddie-tax-and-the-2017-tax-reform/
My #6 would pertain to the muni bond funds held in taxable. While I’m still living in Oregon (9% tax) I’ll sell those as needed for living expenses, then move across the river for at least a year and sell the US municipal bond fund holdings as there’s no Washington state income tax.
My #6 would pertain to the muni bond funds held in taxable. While I’m still living in Oregon (9% tax) I’ll sell those as needed for living expenses, then move across the river for at least a year and sell the US municipal bond fund holdings as there’s no state income tax.
In Berkshire’s 50th anniversary letter to shareholders, he states that permanent loss of capital in Berkshire is a virtual impossibility. He states that it would be reasonable to buy Berkshire at the level he would do share buybacks. Quite simply, that is 1.2 book value. When Berkshire trades at 1.2 book, Berkshire takes Berkshire’s money and purchases the stock because according to Buffett it is undervalued. He tells this secret because he is honest. He wants the person selling him the stock to know that he thinks it is a poor sale for him, and a good buy for Berkshire. I am not saying to do this, but I am saying what Buffett says in his letter which I find fascinating. PoF, I know you bought one share so you could attend the meeting. I went one year. Have you watched the meeting online? They televise them now. I would suggest watching the broadcast version. The rest of the meeting is not as good as the Q and A. Lastly, there is a really good podcast entitled “We Study Billionaires.” It is off topic to this audience, but related and in one sense will prevent confirmation bias from creeping in. This and the back to basics posts are important. There is so much noise out there that one must refresh one’s knowledge on the basics. Kudos to the authors.
I love reviewing the basics. I re-read my residency textbook and seminal papers frequently. Think Drew Brees doesn’t practice his footwork daily?
I still don’t understand though why I should be tax loss harvesting. I can’t eacape the fact that it lowers cost basis and so makes CG larger in the future. So you get to offset those bigger CG later with losses booked earlier. Isn’t that a wash?
Maybe there are special cases that TLH makes sense such as eliminating an unwanted investment and having to take the loss just to get rid of it, but from the vanilla buy and hold Investor standpoint, I’m not convinced. It may be a lack of knowledge, I admit.
You are setting up some tax arbitrage. You deduct losses against your ordinary income now (presumably at a high marginal tax bracket) in return for more capital gain taxes in the future (presumably at a lower CG tax rate).
You can deduct $3,000 in losses per year against ordinary income at your marginal tax rate (and unused losses can carry over). That can be 40% to 50% for some physicians.
As outlined above, there are a number of ways in which those additional capital gains may never be realized or taxed. Even if you do end up paying taxes on the extra gain you get when you lower your cost basis, the tax rate on those will likely be 15% plus state tax.
Also, having some losses banked can keep you from bumping into a higher marginal tax bracket if you take a significant gain for some reason (like selling a vacation home, for example). We could be doing exactly that this year or next.
Cheers!
-PoF
No. You’re missing a few things:
# 1 You get to put $3K a year in losses against ordinary income. Then when it appreciates later, you pay at LTCG rates.
# 2 The time value of money. A tax break now is worth something.
# 3 You might never pay the tax if you die or give the shares to charity first.
Is it huge? No. But there is a significant positive benefit from doing it.
Thanks for the responses. I understand more.
As an example:
I Sell a 10K cost basis for 7K now and book a 3K loss now. I use that now to offset 3K income at 40%. So I save 1.2K now.
In 7 years the 7K is back up to 10K. I sell it and am retired and pay 15% LTCG which is $450. So that’s $750 in savings ($1,200 minus $450) plus $650 interest on the $1200 at 6% per year reinvested = $1400 savings every 7 years per 3K loss booked per year. Makes sense?
I think that covers points 1 and 2 of WCI comments above. Then there is the stepped up basis if I donate benefit which I will never realize the LTCG and also the offsetting capital gains PoF example.
Yes, that’s correct. All upside, very little downside as long as you don’t exchange into a different fund that you wouldn’t be comfortable holding long-term. The easy solution is to only use “trading partners” that you would be comfortable holding indefinitely.
S&P 500 / Total Stock Market are good partners. Track similarly, but clearly not identical. Same with Total International / Ex-US.
Best,
-PoF
Basically you have to either give the money away (die, charity) or earn less (loss harvesting -earn less on paper-, lower taxable income) to pay less in taxes which is just common sense. The fifth presented option limits your investment alternatives (buy stocks with no dividends). There is no free lunch here either.
Or just dont pay the income tax. It is unconstitutional after all.
Unless you don’t believe in amendments, such as, perhaps, the 16th. 🙂
Yes, but the vast majority of us will earn less in retirement.
The stepped up cost basis is huge, too. If you’re unaware, you could sell late in life and pay a whole lot of unnecessary taxes, reducing the money your hieirs (or charitable bequests) will receive.
While the info is basic for some, it’s good review, and it’s worth mentioning that certain taxes can be circumvented in spite of the Benjamin Franklin saying on death and taxes.
Best,
-PoF
Another technique that can occasionally be helpful it to track your investment purchases in lots, and sell off lots with smaller gains first.
And another somewhat more controversial approach is to borrow against an investment instead of selling it directly. I’ve never done that, but if the right situation came up, I would consider it.
Yes — if you’re going to do any TLH or TGH, you will want to have specific lots identified in your taxable brokerage account. Vanguard calls this “specific identification or Spec ID” as your cost basis.
Cheers!
-PoF
“In two minutes, I had a paper loss of about $39,000”, can you please elaborate on this? are the new funds worth 39K less than the older funds?
Step 1. Buy investment
Step 2. Investment goes down in value
Step 3. Sell investment for loss. That loss can be used on your taxes
Step 4. Buy new investment with money from sale. Dollars in new investment are equal to dollars in old investment at time of sale but not time of purchase.
one more clarification, I went on the tax loss harvesting link article
“So the wise investor SWAPS the losing investment for one that is highly correlated with it.”
“The new funds have a correlation with the old funds of something close to 0.99, essentially identical for investment purposes”
I am new to vanguard but is the correlation ratio on there and also is there a minimum ratio at which the you are allowed to count your losses, i.e. does the correlation ratio have to be a minimum of 0.8 or 0.9
No minimal correlation required. IRS wording is “not substantially identical.” But they’ve never defined what that means.
Best place to check Vanguard fund correlations is here: https://adviseronline.investorplace.com/parts/tools/correlation-tool.html?fund1=PRIMECAP
thanks for the link, I just checked it out, it raises another question, what is a healthy correlation value, says you have an individual account with 4-5 ETFs, you would like to avoid too much overlap between the ETFs so whats a good correlation ratio between those ETFs?
As low as possible. 0 is no correlation. -1 is completely negatively correlated. But typically, stock funds are 0.7+ to each other.
I am super impressed by your prompt replies, I don’t know how you do it man, Thank you for everything you are doing, one more question, my colleague referred me to Interactive Brokers to purchase my ETF’s however they charge $10 for starting investment below 100 K. I am doing an experiment where I will invest 10 K on my own using 4-5 ETFs, if I do better than my financial advisor, guess who is getting fired?! what brokerage do you recommend? what has the lowest fees given my current scenario and future scenario of moving my retirement savings there as well?
First, I don’t recommend the whole “me vs my advisor” competition. You don’t to do that for a long enough period of time to get an accurate answer, and an inaccurate answer won’t do any good. If you can design your own financial plan and don’t mind putting in a few buy/sell orders, then do it on your own. If you can’t, use an advisor. It really is that simple.
Second, any of the big, low-cost brokerages are fine- Vanguard, Fidelity, Charles Schwab, TD Ameritrade, eTrade etc. I think Interactive Brokers is famous for low margin rates, but I don’t know much about their customer service or even their commission structure. If a trade commission is $10, it’s cheaper at all of those other places.
If you want really low costs, skip the brokerage account and just buy Vanguard index funds directly from Vanguard. No commissions or fees at all and as long as you put $10K per investment in, you get admiral shares which have an even lower expense ratio. But if I only had $10K to invest and wanted 4-5 funds, you might have to go the ETF route. But at least there are no commissions and no minimums to buy Vanguard ETFs at Vanguard.
That’s what I do. Mutual funds at Vanguard.
Tax loss harvesting is very easy with mutual funds. Exchange one for another. No settlement date, no waiting, just a tidy transaction from one fund to another at the end of the trading day.
Best,
-PoF
Could you please clarify? If I am married filed jointly and my income is under $77,000, then if I sell a property with long term capital gains of $2 Million, I will pay $0 in capital gains taxes???
No. Capital gains are also taxable income.
Maybe on the first few thousand, then you’ll be in the 15% bracket for a while, then 18.8%, then eventually 23.8%.
Thanks for resending this link out in an email. Very timely to an article I just wrote where I put 10 non-dividend stocks into a taxable account to make it more efficient. One of the comments was “Are you kidding?”:
https://seekingalpha.com/article/4534722-dividends-not-for-taxable-accounts?source=all_articles_title