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.
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.
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 Dividendstaying 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!