“It’s not what you make; it’s what you keep!” As mindful investors, it is important that we look for opportunities to legally reduce our tax liability. Strategies may include Roth conversions, health savings accounts (HSAs), tax-efficient investments, business deductions, charitable gifts, tax credits, and so on. In this article, we will be focusing on two unique techniques to reduce the tax liability of your taxable brokerage accounts.
A taxable brokerage account is an investment vehicle you can fund with cash and use to buy securities like equities (stocks) and fixed income (bonds), including mutual funds and exchange-traded funds (ETFs). This account can be opened at a financial custodian like Vanguard, Fidelity, or Schwab, and can be titled as an individual, joint, or transfer on death (TOD) account.
Unlike pre-tax retirement accounts, contributions to taxable brokerage accounts are made with after-tax dollars, meaning there are no tax deductions on the amounts you deposit. These accounts are also not tax-deferred, meaning that most dividend and interest income distributed from the investments is taxable in the year it is received – municipal bond interest is a possible exception. Qualified dividend income is subject to favorable long-term capital gains tax rates (0%, 15%, or 20%), whereas non-qualified dividends and taxable interest are taxable as ordinary income. These dividends are taxable even if they are automatically reinvested – this taxation causes the average cost basis of your shares to increase.
The realization of earnings from these accounts may also be taxable when you sell securities for a gain. Capital appreciation (the increase in share price) is not taxable until it is realized, meaning when you actually sell the investments and have access to the earnings. Short-term capital gains that are realized from the sale of investments held for a year or less are taxable as ordinary income, whereas long-term capital gains from the sale of investments held longer than a year receive the favorable long-term capital gains tax treatment (0%, 15%, or 20%).
The primary benefit of these accounts is the ability to withdraw all money (including earnings) without penalty, regardless of your age. There may be tax liabilities along the way, but these accounts are ideal for short-term savings and the flexibility of liquidation (the ability to quickly convert to cash without losing value). It is best not to use retirement accounts to cover pre-retirement expenses, because they have unique long-term growth potential and the distributions may incur early withdrawal penalties.
Even though losing money on investments is no fun, the IRS is a little sympathetic and allows up to $3,000 of capital losses to be deducted against ordinary income each year, to reduce tax liability. Capital gains and capital losses offset each other, and you can receive this deduction if your losses (whether long-term or short-term) exceed your gains. There are no income limitations, and any capital losses for the year that exceed $3,000 can be carried forward to offset capital gains in future tax years. Rinse and repeat.
Tax loss harvesting is the practice of purposefully offsetting and exceeding realized capital gains with capital losses to reduce income by way of the deduction. This requires the sale of investments that incur realized losses, meaning that the sale price is lower than the cost basis (the price paid to purchase + reinvested income). Be aware that the securities you sell can either be hand selected by lot (Specific Identification) or sold by oldest investment first (FIFO – first in, first out) – these methods can be selected when you sell securities, and can result in different tax consequences.
Once you sell a security at a loss, you can reinvest the proceeds into securities that are different from what you sold or wait 31 days to invest in the same security – this is called ‘avoiding a wash sale.’ If you purchase ‘substantially identical‘ securities within 30 days before or after realizing a capital loss, you will not be allowed to take the deduction. This rule applies to the repurchase of securities across all investment accounts, including retirement accounts. For example, if you sold a share of XYZ stock at a loss in your taxable brokerage account, that loss would not be deductible if you bought XYZ stock in your IRA within 30 days before or after the sale. This loss would be disallowed and the cost basis of the newly purchased share would merely increase by the loss amount. The wash sale rule stops investors from merely churning deductible losses and repurchasing the same securities right away.
As previously mentioned, selling investments with long-term capital gains receive favorable tax treatment, including the possibility of a 0% tax rate on the earnings! In year 2020, realized long-term capital gains are taxed at 0% if taxable income is at or below $40,000 if single, or $80,000 if married filing jointly. Keep in mind that ‘taxable income’ comes after the standard or itemized deductions in the income tax formula, so your adjusted gross income (AGI) would be higher than this dollar amount.
Tax gain harvesting is the practice of selling securities with long-term capital gains while still remaining within the 0% capital gains tax bracket. This opportunity could effectively reset your cost basis and turn this portion of your taxable brokerage account into a tax-free growth vehicle, similar to a Roth IRA. The proceeds from the sale can purchase the same or substantially identical securities right away, since wash sales only apply to realized losses.
Make sure to measure twice and consult a tax professional before assuming you fall within the income range to harvest your tax gains, especially as these realized gains are still considered as income. Also be careful when calculating your taxable income in general, especially as unexpected bonuses and investments can add taxable income at the very end of the year and push you into the higher marginal bracket.
As a final reminder, tax gain and loss harvesting are only effective in taxable brokerage accounts. You cannot receive these tax benefits by selling securities within tax-deferred retirement accounts, such as 401(k)s, 403(b)s, and IRAs.
I hope this knowledge will help you along your path to financial independence, and will allow you to KEEP more of your hard-earned money!
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