Many of us are, as of this writing, furiously rushing to finish up our tax filings and swearing on all we hold sacred that next year we’re going to get an earlier start.
If that describes you, then just dialing down your anxiety level would be reward enough. But if you start early enough – and by “early enough” we mean December – you can significantly reduce your tax liability as well as your blood pressure.
Gaining from losses
If you haven’t heard of tax loss harvesting before, that’s okay. Maybe it wasn’t important to you before. But with tax increases on the horizon for many of us, this is the perfect time to get caught up on the subject.
Tax loss harvesting is the strategy of selling underperforming assets at a loss in order to offset the tax bill realized on the sale of other assets. When you sell stocks, bonds or real estate at a profit, you incur a capital gain. At the moment, capital gains are taxed at roughly half the rate of regular paycheck income. The intention is to reward risk taking and investment in productive enterprise.
For what it’s worth, 2021 marks a century of capital gains being taxed at a lower rate than wages in America. The income tax was instituted in 1913 and, eight years later, high net worth individuals benefited from a new tax break. While the top bracket’s marginal rate was set to 58%, their capital gains were levied at only 12.5%.
President Trump’s signature Tax Cuts and Jobs Act didn’t cut the capital gains tax per se, but it did decouple it from tax brackets. As a result, according to the Tax Policy Center, more filers could better take advantage of it.
Few people expect that law to stand, though. As soon as the Biden administration is done pushing through its multi-trillion-dollar agenda, it will come time to pay for it. You can reasonably expect capital gains to be taxed at or close to wages in 2022, if not 2021.
If tax harvesting had been a sound strategy for the past hundred years, it just became a critical one.
Short-term capital gains – the gains realized on assets sold within one year of purchase – have long been treated as regular income and enjoy no favorable tax treatment. Harvesting only works when you sell assets you’ve held for more than a year and let the gains and losses offset each other.
However, be advised that there’s a “wash-sale rule” which can come into play. If you sell a security for tax loss harvesting purposes, you can’t buy that same security back until at least 30 days after the sale, or you negate the whole transaction.
Another wrinkle is the net investment income tax, a 3.8% surtax on all realized capital gains – short- or long-term – for taxpayers whose adjusted gross income exceeds a certain threshold. That threshold is currently $200,000 for individuals or $250,000 for couples. A new tax law could keep the capital gains tax itself intact but raise the NIIT rate or threshold with the same effect.
Then there’s the Section 31 transaction fee to be aware of. This is a levy on securities trading so that, whether your trade is a winner or a loser, you still have to pay a sales tax on every transaction. It’s so low right now – about 2 cents per $1,000 traded – that you might have never even noticed it, but that could change with the stroke of a pen.
This then is the financial adviser’s dilemma: While the general shape of things to come can be imputed by the rhetoric coming out of Washington, we have no specifics in place yet to plan around.
However, we will surely know more about the tax landscape later in the year and will have more concrete strategies to share with clients at that time. To be sure, tax harvesting will almost certainly be part of those strategies, as well as such tools as charitable giving and intergenerational transfers.
Maybe it feels too early to schedule an autumnal call with your financial adviser but, as you’ve noticed over the past couple weeks, it’s never really too early.