Along with the key tenets of successful investing (asset allocation, diversification, rebalancing), being tax efficient can improve your financial security. Remember, it’s not what you make, it’s what you keep.
A strategy that will work now for some and can be planned for in the future for others is utilizing a window for tax-free capital gains. There is no capital gains tax due for assets sold after being held more than one year by people in the 15 percent tax bracket or below. This applies only to non-retirement accounts.
A couple filing a joint federal tax return could have up to $75,300 taxable income in 2016 and not be taxed on long-term capital gains. A single tax filer could have taxable income up to $37,650 and pay no tax on realized long-term capital gains.
The savings can essentially boost your after-tax returns, so it’s important to work with your accountant or adviser to determine how you can structure your income to be eligible for this option. It won’t apply to everyone, but you may be surprised how many this does apply to. A couple could have gross income approaching $100,000 before tax credits, standard or itemized deductions, and personal exemptions that reduce their taxable income down to the 15 percent bracket.
This is not a scheme that would trigger an audit. The tax-free capital gains brackets were made permanent with the Taxpayer Relief Act of 2012.
So how might this work? Imagine you and your spouse have $65,000 of taxable income. This leaves you with $10,300 of room before the top of the 15 percent tax bracket. If you have investments that have grown in value, you could realize $10,300 of capital gain tax free. This would save you a little over $1,500 compared with a less-well-executed strategy where the capital gain was taxed.
This presents a planning opportunity that may be attractive to retirees in their first few or even first several years of retirement. Even if you have started Social Security, your taxable income could be well below $75,300. If you are secure enough to retire and not need to immediately start Social Security benefits, you could keep your taxable income very low while earning deferral credits on your Social Security for a larger benefit later. In these low-income years, you could potentially fill up the 15 percent tax bracket with tax-free capital gain each year.
Why Sell a Winner?
If you own a successful investment, you may feel like holding on to it hoping positive momentum continues. But you can sell it and buy it right back if you’d like. There is no tax penalty (wash-sale rule) on holdings sold at a gain and repurchased. If you think the investment has further growth potential, you can buy it again immediately. You will have raised your taxable cost basis so that the next time you sell it you won’t be paying years of built up gains. You receive the benefit of a cost basis step up at death without dying.
Imagine you have an investment that has grown in value by $10,000. You hold on to it instead of selling in a year where you could have sold it without a capital gains tax. Over the next year it adds another $10,000 in value. You decide to sell but by now your taxable income is past the threshold for tax-free capital gains. A 15 percent capital gains tax on $20,000 of realized gain costs $3,000 that could have been avoided.
Harvesting capital gains is not the intuitive path for taxable investments. Many people look instead to harvest capital losses for tax relief. It would actually be better to wait to utilize capital losses in years when you do not qualify for tax-free capital gains instead.
Strategy Requires a Plan
As with anything related to the tax code, the tax-free capital gains strategy unfortunately isn’t simple. You must be aware of all forms of income before year end. You have to sell investments during the year to realize gain, not just before tax-filing in April, expecting the activity to apply retroactively. It’s also important to understand your mix of ordinary income and capital gains income and how deductions or exemptions can apply to one but not the other. Adding capital gains income can increase your adjusted gross income, which could affect taxation of Social Security or eligibility for deductions, offsetting the benefit of the tax-free capital gains.
Coordination and planning are therefore important. And ideally, the tax savings, especially if applied over a series of years, could be worth more than the cost and time required to plan.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at firstname.lastname@example.org.
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