Some parts of this blog were updated on March 14, 2018
The impact of efficient tax management within investing is substantial. Tax management just within the domain of investing can increase your portfolio’s return by 1% per year. Invested over 35 years, that can lead to a 40% difference in the value of your portfolio1. Proper tax management can help increase the amount of money in your pockets, which ultimately increases the long-term chance of achieving your financial and life goals.
Taxes & Capital Gains
You’ve probably heard of capital gains taxes. You owe these taxes only if you realize a profit from the sale of an investment or business. Before you pocket your windfall, you must share some of it with Uncle Sam. While that doesn’t sound too bad, wouldn’t it be better if you could decrease the share that you must pay and increase what you keep?
Long-Term vs. Short-Term Investments
The amount of taxes you will pay on your realized capital gains differs greatly depending on how long you owned your asset. For example, let’s say you owned a stock for less than one year – you’ll owe taxes based on your ordinary income tax bracket. If you owned the stock for more than a year, on the other hand, you’ll pay a lower long-term capital gains tax rate, which can be anywhere from 0% to 20%, depending on your tax bracket. If you earn more than $200,000 (single) or $250,000 (married), you will be subject to an additional 3.8% Net Investment Income Tax.
That’s why most investors should focus on buying investments they plan to hold for at least one year; in most cases, capital gains taxes owed will be significantly less on long-term gains than they are on short-term gains.
Tax Loss Harvesting
But there is another way to manage capital gains taxes: through tax-loss harvesting. Essentially, you sell some of your losses to offset your gains. Typically, tax-loss harvesting works best through portfolios of individual stocks in taxable investment accounts. You sell stocks within your portfolio that have dropped in value, and ideally, you sell enough stocks that have lost value to cover the amount of appreciation from the stocks you are selling for a gain. You can even offset up to $3,000 in other income if your capital losses exceed your capital gains. Tax loss harvesting can help you rebalance your stock portfolio at the same time, and can result in a higher net after-tax return.
Tax-loss harvesting works even if you want to maintain exposure to the stocks that have lost value, but there are some rules. To avoid the “wash sale” rule, you cannot repurchase the same or a substantially identical stock within 30 days before or after selling at a loss. You can, however, buy an exchange traded fund (ETF) covering the broad market and hold it during the wash-sale period. This allows you to maintain exposure to the industry until you can repurchase the stocks you sold. If the security you sold was a basket of stocks, such as an ETF, you cannot simply buy the same type of ETF from another provider. Tax loss harvesting can be complex, so consulting a financial and tax advisor is recommended.
We routinely use this method to help most clients offset all capital gains and even hit the $3,000 maximum deduction amount. Schedule an appointment with a Personal Capital advisor to find out more.
Learn more about taxes and how they fit into your investment strategy by reading our free Personal Capital Tax Guide for the Savvy Investor.
This blog is for informational purposes only and is intended to offer guidance; not specific legal or tax advice. Clients are advised to consult their personal estate attorney and CPA before taking action based on this advice.