Do You Have a Taxable Investment Account – Doctor?

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Is it Time to Harvest?

[By Lon Jefferies MBA CFP®]

Lon JeffriesTax harvesting is the process of selling assets for the purpose of creating either long-term capital gains or losses to minimize your tax bill. This procedure is usually conducted near the end of a calendar year.

While many people are familiar with the concept of tax loss harvesting, fewer physicians or clients are familiar with the more recently developed process of tax gain harvesting. Between these two procedures, virtually everyone with a taxable (not tax-advantaged) investment account should make adjustments to their portfolio before the year ends.

Who Qualifies For the 0% Capital Gains Rate?

First, it is important to understand that capital gains (the growth on investments within a taxable, non retirement investment account) are taxed differently than ordinary income (wages, pensions, Social Security, IRA distributions, etc.). While short-term capital gains (recognized on the sale of assets held less than a year) are essentially considered ordinary income, long term capital gains, or recognized gains on assets held more than a year, are taxed at advantageous tax rates. While ordinary income tax rates range from 10% to 39.6%, capital gains tax rates range from 0% to 20%.

Second, it is crucial to understand what enables a taxpayer to qualify for the 0% capital gains rate. If a taxpayer is in the 10% or 15% ordinary income tax bracket, they qualify for the 0% long-term capital gains rate.

For a married couple filing jointly, the 15% tax bracket ends at $73,800 of taxable income ($36,900 for single taxpayers). Thus, if a married taxpayer has a taxable income (which includes long-term capital gains but is also after deductions and exemptions) of less than $73,800, all their long-term capital gains will be tax free. If the taxpayer is in a tax bracket anywhere between 25% and 35% (taxable income of $73,800 and $457,600, or between $36,900 and $406,750 for single tax filers), they will pay long-term capital gains taxes at 15%. Only those in the top tax bracket of 39.6% (married taxpayers with a taxable income over $457,600 and single taxpayers with taxable income over $406,750) will pay capital gains taxes at 20%.

Tax Loss Harvesting

During the calendar year, assets have been purchased and sold in most taxable investments accounts. The sale of an asset creates a net gain or loss, both having tax implications. Investors should have an understanding of what their long-term capital gains tax rate will be so they can determine whether a taxable gain or loss is preferable.

For instance, an individual who does not qualify for the 0% capital gains tax rate may wish to minimize the amount of taxable gains they recognize during the year, which would reduce their tax bill. If the investor currently has a net long-term capital gain (which is probable after the strong year the market had in 2013), then it is likely worthwhile to sell any assets in the portfolio that are currently worth less than the investor’s purchase price. This tax loss harvesting would reduce the net gain recognized during the year and lower the investor’s tax bill.

In some cases, by taking advantage of all potential losses within a portfolio an investor has the ability to negate all capital gains created during the year, completely eliminating their capital gains tax bill. Further, the IRS will allow investors to recognize a net capital loss of up to a -$3,000 per year. This -$3,000 loss can be used to lower the taxpayers ordinary income. This is particularly advantageous in that the capital loss reduces a type of income that is taxed at higher tax rates.

Harvesting Gains

Harvesting gains from a taxable portfolio is a more recently developed concept. Once the 0% long-term capital gains tax rate became a permanent part of the tax code with the passing of the American Taxpayer Relief Act of 2012 (signed January 2nd, 2013), in some scenarios it began making sense to recognize long-term capital gains on purpose to potentially avoid a larger tax bill in the future.

Suppose a taxpayer’s taxable income is consistently $65,000 a year. Additionally, suppose our hypothetical taxpayer won’t withdraw funds from his taxable account during the next few years, but may need a large lump sum distribution five years down the road. Recall that the 0% capital gains rate ends when a married taxpayer’s taxable income (which includes long-term capital gains) exceeds $73,800. Consequently, this hypothetical taxpayer has the ability to recognize $8,800 ($73,800 – $65,000) in long-term capital gains every year without increasing his tax bill. If this $8,800 in gains is recognized every year by simply selling and immediately repurchasing appreciated assets, he would raise the cost basis of his investment by $44,000 ($8,800 gain recognized annually for five straight years). He could then sell and withdraw that $44,000 without creating a tax liability.

Alternatively, if the investor does not harvest gains during the years when no distributions are taken, withdrawing $44,000 of gains five years down the road would create a sizable tax bill. He would still be able to recognize $8,800 of gains tax free in the year of distribution, but the remaining $35,200 of gains would cause his taxable income to be over the $73,800 limit, eliminating access to the 0% capital gains rate. That $35,200 would be taxed at the 15% capital gains rate, creating a federal tax bill of $5,280. With proper planning, this significant tax bill can be avoided.

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Portfolio analysis

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The Bottom Line

Tax harvesting has no purpose in tax-advantaged retirement accounts such as IRAs and 401ks because all distributions from these accounts are taxed as ordinary income. However, taxable individual or trust investment accounts can almost certainly benefit from tax harvesting. Speak to your accountant and financial planner to understand whether capital gains or losses are desirable for you this year and determine the amount of taxable gains already recognized. This will help you determine what type of harvesting should take place.

Tax harvesting can be a difficult and confusing concept. However, a competent financial planner who utilizes this procedure within your taxable investment account can significantly lower your tax bill. Speak to your adviser to ensure you are reaping the tax benefits available to you.

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OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

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3 Responses

  1. BUSINESS TAX PROVISIONS RETROACTIVELY EXTENDED BY THE TAX INCREASE PREVENTION ACT OF 2014‏

    On Dec. 16, 2014, Congress passed the “Tax Increase Prevention Act of 2014” (TIPA, or “the Act”), which the President is expected to sign into law.

    The Act extends a host of tax breaks for businesses, including the research credit, the new markets tax credit, the employer wage credit for activated reservists, enhanced charitable deductions for contributions of food inventory, and empowerment zone tax incentives.

    I am currently reviewing the provisions of the law to make sure none of our favorite deductions have been eliminated in the negotiation process.

    More details to follow.

    Bobby
    [Managing Partner]
    Whirley & Associates, LLC + ProActive Advisory
    Certified Public Accountants
    2500 Northwinds Parkway
    Suite 190
    Alpharetta, GA 30009
    770.932.1919

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  2. What I Learn From Tax Loss Harvesting

    In the last two days I have been doing tax loss harvesting for my clients. According to Google,

    Tax loss harvesting is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” a loss, investors are able to offset taxes on both gains and income. The sold security is replaced by a similar one, maintaining the optimal asset allocation and expected returns.

    That sounds simple enough, but actually I learned a few things doing tax loss harvest. 1) You can make money and still claim a tax loss; 2) The difference between TTM Yield vs 30 Day SEC Yield and what to use to select a bond fund.

    Take one high net worth client for example, he has about $500k of DWFIX, an international bond fund. I sold that to realize a $31k loss that he can use for tax deductions. But during the three years that the position was in his portfolio, it generated more than $100k in incomes. So he makes money in this position but still gets to claim a tax loss. How nice!

    So lesson number one: investment returns come from two sources: incomes and capital gains. Incomes can not be negative, but capital gains can. When they are negative, they are called capital losses. Regardless of incomes, always realize capital losses ASAP.

    For a person in the top tax bracket – combined federal and state marginal tax rate of over 50%. $31k in harvested capital loss is worth more than $15.5k. Not bad for a click of the mouse.

    TTM Yield is trailing twelve month distribution to investors from a fund divided by current value of the fund. The distributions could include returns of capital, which makes this measure useless in comparing across funds.

    30-Day SEC Yield is the distribution received by the fund from its holdings that include only dividends and interests (in the last 30 days but annualized) divided by its current value. This measure is forward looking, it does not include returns of capital and it allows investors to compare across funds.

    Take DWFIX for example, the fund has TTM yield of 6.53% but a 30-Day SEC Yield of only 1.01%. 6.53% is what DWFIX has returned to investors last year that include quite a bit of return of capital. 1.01% is what DWFIX gets from its holdings which is much more representative of the fund’s earning potential.

    That’s why I replace DWFIX with VWEAX that has a TTM yield of 5.81% and a 30-Day SEC Yield of 6.35%.

    Michael Zhuang

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  3. Harvest Tax Losses

    Tax loss harvesting can be an effective tool to reduce taxes. If any investments in your taxable accounts have lost money, those investments can be sold, and the loss captured. This loss can then be used to offset gains in other investments or potentially lower your 2021 tax bill. Up to $3,000 ($1,500 if you are married filing separately) of net capital losses can be deducted against ordinary income, self-employment income, and interest income. If you have captured losses above these amounts, the excess can be carried over to future years to offset gains or deduct against income. Tax loss harvesting must occur before 12/31/2021 to count towards 2021.

    Source: Jeff Witz, CFP®, Physicians Practice [11/17/21]

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