With the market rallying like crazy this past year, you might have significant capital gains on stocks right now.
Now might be a good time for some of you investors to harvest some capital gains. Maybe you’re looking to buy a house. Or maybe you just want to rebalance your investments.
But when you sell stock, you pay taxes on the sale.
And capital gains taxes can get complex because the effective tax rate you pay when you sell stock depends on whether there are long-term vs. short-term capital gains, whether there are any long-term vs. short-term losses, what your marginal tax rate is, and even whether you are required to pay the Medicare Surcharge Tax.
That’s why this week I invited CFA Scott Stratton to explain the intricacies of how capital gains taxes work. We discuss key rules and strategies you need to know to do thoughtful capital gains tax planning. If you want to learn how to minimize capital gains taxes, then don’t miss this episode.
- What types of assets capital gains taxes apply to
- Difference between short-term vs. long-term capital gains tax treatment
- How capital gains and losses work in tandem come tax filing time
- How to harvest capital losses and harvest capital gains
- Current proposed legislative changes to capital gains tax rates
- What investors may want to consider doing now before potential changes take effect
What other tax planning questions do you have about capital gains taxes? Let me know by leaving a comment.
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- Good Life Wealth Management
- Tax Loss Harvesting: Rules and Strategies with Bob Dockendorff (HYW022)
- How to take a year off, earn 6 figures, harvest capital gains, do Roth conversions…and pay zero taxes on it all
- How to earn 6 figures and legally pay zero taxes (updated for 2020) (HYW021)
- Avoiding capital gains tax on real estate: how the home sale exclusion works
- How the Home Sale Capital Gains Tax Exclusion Works (HYW033)
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:23
My guest today is Scott Stratton.
Scott is the founder of Good Life Wealth Management, a registered investment advisor focused on helping individual investors achieve financial independence with a focus on tax efficiency.
Previously, he was the Director of Financial Planning for another financial advisory firm focused on high net worth individuals, where he was responsible for researching matters related to asset allocation, taxes, and Social Security.
Prior to that, he worked as a Financial Advisor at Goldman Sachs Wealth Management, and he holds both the CFA and CFP designations. He is also the author of a book called “Your Last 5 Years: Making the Transition from Work to Retirement,” and in a prior life, he was a music professor.
Scott, thanks so much for joining us today to share insights and tips on capital gains taxes!
Scott Stratton 02:09
Thank you. My pleasure.
Andrew Chen 02:10
I’d love to start out a little bit more about learning about your background. Can you tell us a little bit about your background and what kind of advisory work you do when it comes to capital gains taxes specifically?
Scott Stratton 02:22
I didn’t study finance in college. I was actually a music major, but I took economics courses for fun, and it was always a keen interest and passion of mine. And I got out of college, had my doctorate, I was teaching at a university, but I was spending most of my time investing and thinking about investments and stocks.
Within about five years, I was making more in the stock market than I was from being a music teacher. That’s really what got me interested in financial planning, wanting to do it for myself, and to take my background as an educator and being able to think about, research, and explain abstract concepts, and be able to help people, and take that impact to helping people with their finances.
The tax portion has already been a really important part. Before I became a financial advisor, I was day trading stocks. This was after the tech bubble had melted down, so I wanted to stay away from large cap stocks, so I was day trading small cap companies.
At the end of the year, I looked back and realized I had made about a 28% gain doing all short-term trades, and I thought, “This is great. I’ve done way better than the S&P 500.”
Really proud of what I had accomplished. Put in a lot of time.
And then I looked up what the index had done for small cap value, which is the area I was trading, and it did 28%. So I had spent a tremendous amount of time to trade myself and do exactly the same return as I would have had if I had just done an index fund, but to add insult to injury, I now had to pay short-term capital gains taxes on it, as opposed to just being in the index where I would have actually been able to have gotten a long-term capital gains treatment.
At the end of the day, it was a lesson to learn that the taxes really do matter. And then, as a professional working with high net worth investors, most of their money is outside of an IRA, outside of a 401(k), and there your decisions really make a big impact.
Andrew Chen 04:30
Excellent. Most folks in my audience are going to know what capital gains taxes are, so I wanted instead to get into some nitty-gritty specifics.
First, do capital gains taxes apply to any asset sale, no matter whether it’s stocks and bonds or a house, boats, artwork, etc.? Are there any major asset classes where the normal capital gains tax regime does not apply, or where it applies differently?
Scott Stratton 04:57
There are a couple of situations that are exceptions to the normal capital gains rules. The first, of course, is your primary residence.
Thinking about your home, when you sell a primary residence, there’s a capital gains exclusion. As long as that was your residence for two out of the past five years, there’s an exclusion of $250,000 single or $500,000 if you’re married filing jointly. That’s if it’s your personal residence.
Another exception is for collectibles. When we talk about collectibles, when the IRS says collectibles, they’re talking about art, antiques, rare coins, rare stamps, but also things like gold and silver, and not just owning bullion, but actually even the ETFs for gold and silver. Those also count as collectibles.
Those are taxed at a 28% long-term capital gains rate, which is a little bit unusual because it creates some different planning scenarios. First of all, if you can hold those in an IRA, that’s going to be more tax-efficient than holding them in a taxable account because you’re not able to get that lower capital gains rate.
But second, if you’re in a lower tax bracket, you might actually be better off selling them as a short-term capital gain before the one-year mark rather than holding on and having it turn into a long-term capital gain and being at the 28%. So, that’s another area to consider.
And then a third one would be looking at depreciation recapture. If you’re buying a rental property, if you have rental real estate, investment real estate, and you’re depreciating that asset over time, let’s say you buy a house for $300,000 and you depreciate $100,000 of that, so now your cost basis is only $200,000.
If you go and you sell it for $350,000, you’ve got a $50,000 capital gain and $100,000 of depreciation recapture. That’s called a 1250, and that is going to be taxed at 25%.
So, those are some of the big exceptions to the normal capital gains roles.
Andrew Chen 07:09
And then the $50,000 is also covered by 1031 if you buy another property, right?
Scott Stratton 07:14
Right. That’s one of the great ways of avoiding that depreciation recapture and the capital gains: by rolling your investment property into a new one.
Andrew Chen 07:25
Any other major differences by asset class that you see, or are these the big ones?
Scott Stratton 07:33
Those are the main ones, thinking about where you’re holding things, your asset location. A lot of what I’m trying to do in optimizing portfolios for tax efficiency is finding the right asset class.
I would say, for investors who are investing in stocks and bonds, you have a couple of things to consider. Obviously, you can be much more efficient if you avoid short-term capital gains and always hold on to things for at least one year.
When you have an exchange-traded fund, an ETF, usually those are very tax-efficient because they generally do not have capital gains distributions at the end of the year. 2021 is shaping up to be a fantastic year for a lot of mutual funds. And for those actively managed mutual funds, when they trade inside of the portfolio, they’re going to have a capital gains distribution at the end of the year to shareholders.
Some of those are going to be pretty substantial here at the end of the year, so even if you haven’t sold your mutual fund in a taxable account, it’s very possible that you could still end up seeing a tax bill for those capital gains.
Andrew Chen 08:38
Can we dive into some of the specifics on the difference between short-term and long-term capital gains, and what do investors need to know about each? I’m talking about things like holding period, the rates, and the sequencing of offsets, etc. Maybe you could comment broadly, and then I’ll have a bunch of specific questions.
Scott Stratton 09:00
Your short-term capital gains are assets that are held less than a year. Long-term are more than a year. Currently, there are three tax rates for long-term capital gains: 0%, 15%, and 20%.
Most people are going to fall into that 15% category. However, if you’re in the lowest tax bracket, you could be potentially at the 0% capital gains rate for long-term capital gains. That would be, for 2021, a married couple with taxable income of less than $80,800, or a single tax filer with taxable income of less than $40,400.
For those people, if you’re at that 0% capital gains rate, it can make a lot of sense to actually harvest your gains on a regular basis to avoid allowing them to accrue. Or if you think your income is going to be a lot higher in future years, paying a little bit of taxes every year or harvesting a little bit of the gain so you don’t have to pay taxes at the 0% rate can be very good.
Andrew Chen 10:00
Just to clarify, that means selling and then buying back when you say harvesting the gains?
Scott Stratton 10:07
Yeah, selling and then buying back.
If you have a gain, there’s no “wash sale rule.” When you have a gain, you can sell it and buy it back right away. Wash sale rule only applies to harvesting losses.
Andrew Chen 10:21
And just very briefly, for those who are a little rusty, what is the “wash sale rule”?
Scott Stratton 10:27
The “wash sale rule” in a taxable account, if you sell something for a loss, you cannot buy it back, either 30 days before or 30 days after a substantially identical security. This is just to keep you from taking the loss and then immediately buying it back. You have to wait at least 30 days.
The way that usually works for myself, as a portfolio manager, is if I’m using exchange-traded funds and I were to sell out of the Vanguard 500 index, I could immediately go into another large cap ETF, either from Vanguard or from iShares or State Street or one of the competitor ones. As long as it’s not identical, you can go back and do a similar security right away.
I don’t recommend people wait 30 days, unless you absolutely have to have that stock or that fund. You’re better off finding one that’s similar and just doing the substitution.
Andrew Chen 11:22
And by substantially identical, because there isn’t very crystal clear guidelines from the IRS on this. There’s lots of examples. There’s some obvious ones, like if you sell Amazon and then you buy Nike, those are clearly not substantially identical.
But if I sell Vanguard, just the plain vanilla S&P 500 fund, and I buy Fidelity’s version of that, how do I know whether or not that’s substantially identical?
Scott Stratton 11:52
I would try to avoid that one, particularly of an S&P 500 index fund, because that could be potentially the same holdings. Although, I’ve heard some people say that that’s okay because it’s a different expense ratio, or it might be managed a little bit differently. I don’t want to try to shave it that thin.
Another example of one where they do say it’s substantially identical is options. If you had Amazon, you can’t sell your Amazon stock and then buy an option on Amazon stock. That would be considered substantially identical.
Andrew Chen 12:27
Are there any individual stock trades that could potentially be considered substantially identical, or would all those be considered not?
Scott Stratton 12:36
There could be. I’d be careful of doing ones that are different share classes of the same company.
Andrew Chen 12:42
But different companies?
Scott Stratton 12:44
Different companies, no problem.
Andrew Chen 12:53
You were talking about the three different tax rates for long-term gains. And then there’s the healthcare surcharge, the NIIT tax, 3.8%. When does that kick in again?
Scott Stratton 13:06
On top of your long-term capital gains tax, there’s the net investment income tax (NIIT). It’s commonly just referred to as the Medicare surcharge. That’s an additional 3.8% tax that goes on any passive or investment income, so that will apply to any capital gains.
That kicks in at $200,000 single, $250,000 married. So the real long-term capital gains rates then are 0%, and then 15% once you hit $80,000 of income married, and then if you’re married, then at $250,000, you’re going to go up to 18.8% (15% plus the additional 3.8%).
And then everyone who is in the 20% long-term capital gains rate, which is currently $501,600, everyone who is in that tax bracket is also going to be hit with that Medicare surtax of 3.8%, so all of those people will be in the 23.8% long-term capital gains rate.
Andrew Chen 14:15
That’s the long-term side. Can you talk a little bit about the short-term side?
Scott Stratton 14:19
Short-term capital gains means that they’re going to be taxed as ordinary income, so that’s going to fall into your ordinary income tax bracket of 10%, 12%, 22%, 24%, and so on.
Andrew Chen 14:32
That’s pretty straightforward. In a year in which you are selling assets that’s going to result in a tax recognizable gain, can you talk a little bit about the sequencing of how gains and losses are offset?
I understand, in this part, there’s actually some sequencing rules. Maybe your tax software will just take care of it for you, but for folks to know, for planning purposes, how should folks be thinking about what the flat rules are for short- and long-term gains and losses in the sequencing of offsets?
Scott Stratton 15:16
The first thing is that you always offset like-kind trades. That means we’re going to group all of your short-term trades together, and all of your long-term trades together.
So, you’re looking at all of your short-term trades. Does that add up with a net gain or a net loss? Then you look at all of your long-term trades and see if any of those, together as a group, have a net gain or a net loss.
That’s where typically the two would both apply tax-wise. If you have a short-term gain and you have a long-term gain, you pay the short-term rate on the short-term, and you pay the long-term rate on the long-term capital gains.
If, however, you have a loss in one of those categories, you can use it to offset the other. Let’s say you have a gain on the long-term side, but you have some short-term losses. You can use those short-term losses to offset your long-term capital gains.
Of course, that’s less valuable because the short-term rate is higher. The ideal thing is you want to try to offset those short-term gains, or preferably, not have any short-term gains that you’ve realized.
Andrew Chen 16:21
I want to circle back to that here in a moment, but then can you also talk about the annual ordinary income offset and the carryover rules?
Scott Stratton 16:33
When you combine both your short- and long-term, and you have a net loss for the entire year, you can take $3000 of that and count that against your ordinary income. That could be salary or wages or your other types of income that you have. And then any loss can be carried forward indefinitely.
The nice thing about that is if you have a long-term loss, the gain would only be 15% potentially that you’d be offsetting. But if you can now use that to offset your ordinary income, that might be at a higher rate. It might be on the 24% tax bracket but only paying 15% on capital gains.
So, if you can strategically try to harvest those long-term losses, and then use them to offset ordinary income, you’re getting a little bit of arbitrage using a lower rate to offset a higher rate.
Andrew Chen 17:22
As I recall, the $3000 is never adjusted for inflation, right? It’s just frozen.
Scott Stratton 17:28
It is not.
Andrew Chen 17:31
So it does not have an annual congressional adjustment, like many other things in the tax code do?
Scott Stratton 17:35
Correct. That’s just been stuck there.
Andrew Chen 17:42
So you can roll over indefinitely, but it’s like an interest-free loan that you give to the government effectively until you use it up, right?
Scott Stratton 17:53
The nice thing is that you’re holding that, so that way, you can offset future gains. The next year, if you have a really big year and you decide you want to harvest a lot of gains, you’re able to do that. It also gives you a little bit of budget to do things like rebalance, or if you’re going into retirement, you can harvest some of those and not pay any taxes on them.
Andrew Chen 18:13
Let’s say you did all that. You took your $3000, but you still have losses left over at the end of the year. You carry them forward.
The next year, does the same sequencing apply? You look first for a like-kind gain to offset against, or does it just go straight to offset your ordinary income?
Scott Stratton 18:33
No, you will be looking for the like-kind again, so you’re retaining the character of the short-term and long-term losses from the previous year.
Andrew Chen 18:41
So, when you offset against ordinary income, the $3000, and you carry over the next year, you’re going to have to remember. Or maybe your tax software or your tax advisor will remember it for you, so they know how to apply it the next year.
Scott Stratton 18:57
Yeah, it will show on your current tax return what the carry forward is.
Andrew Chen 19:10
That makes sense. And these carryover rules are the same for both short and long term? There’s no difference, and they’re treated the same, is that right?
Scott Stratton 19:20
Andrew Chen 19:27
You talked a little bit about the potential arbitrage opportunity, but I wanted to really make that clear. There’s basically four possible scenarios.
You can have short-term gain, and that gets offset against long-term loss. You could end up in that scenario. You could have long-term gain that gets offset against short-term loss.
You could have short-term losses that get offset against long-term gain, and then the opposite, long-term losses get offset against short-term gains. Some are better than others, obviously.
It sounds like, as an example, if your ordinary marginal rate is 32%, but your capital gains rate is only 15% (I don’t know if that would actually be true, but hypothetically), you sell at a long-term loss, and due to your configuration of losses and gains, you’re able to offset against some short-term gain in the current tax year.
Normally, you’d be taxed ordinary income, so in this example, 32% on your short-term gain. But here, because you have some long-term loss, you can offset that and capture that arbitrage.
And it sounds like you’re not on the hook to pay the gap, the difference between the two rates. That’s just a benefit to you as the taxpayer. Is that correct?
Scott Stratton 20:47
It is. That’s the nice thing about that $3000 a year. You can use that even if it is a long-term loss, where you’re only potentially saving 15% in gains, you can offset that against your ordinary income tax rate.
Andrew Chen 21:01
And then, of course, the more unfortunate scenario is the opposite: You have a short-term loss which is worth a high rate. You don’t have a short-term gain to offset against, so you offset against long-term gain and you lose that arbitrage opportunity, is that right?
Scott Stratton 21:17
Yeah. And if that was the case, you could look if there was a short-term position that you wanted to get out of. That would be a good time to harvest that short-term loss, to use that loss to offset a short-term gain if there was a position that you wanted to sell.
In general, I try not to trade frequently now, so I’m mainly focused on long-term gains. However, when we have an opportunity to sell, like March of last year, I did a tremendous amount of tax swaps where I’d sell out of one ETF that was at a loss and buy a similar ETF.
In some cases, we were able to lower our expense ratio, or get into a little more liquid fund, or get into a fund that was virtually identical, but to harvest those losses, which ended up being quite beneficial. And now we do have some tax losses that we can apply even for several years into the future.
Andrew Chen 22:10
Are there any tips or pointers that you will commonly advise to clients or just to investors/taxpayers on how to manage their short- and long-term gains strategically, so if they are ever in this situation, they’re on the beneficial side of the arbitrage rather than the side that hurts them?
Scott Stratton 22:38
I think it’s probably more important just to look at trying to maintain their overall targets within the portfolio. We do a lot of optimization for taxes, but at the same time, we have to make sure we don’t let the taxes become the primary determining factor.
It’s relatively easy to make trades because there’s so many thousands of exchange-traded funds where you can do this in a very tax-efficient way. Every December, we’ll look at this, and then, when there’s a big tax dislocation, we’ll also be looking at this as well in all of our taxable accounts, how to best manage these gains and losses.
Andrew Chen 23:15
Speaking of harvesting, because we’ve been talking about it a good deal, can you explain a little bit about what harvesting losses and harvesting gains entail? How does it work tactically?
Scott Stratton 23:32
For people who are in that 0% long-term capital gains rate, I think it does make sense to try to harvest some of those gains on an annual basis. If you think that there’s going to be higher tax rates in the future, you might also want to be trying to harvest some of those gains on a regular basis.
There might be some changes to tax law that would also encourage people to harvest some of those gains going forward. As far as harvesting the losses, I think for most people doing that on an annual basis, or when you’ve moved quite a bit and really need to rebalance the portfolio, that’s the time to look at: are there any losses to harvest as well?
In general, when we’re thinking about rebalancing a portfolio, if you’re rebalancing back to a target, you’re looking to sell your winners. So the process of rebalancing is always taking what is moved up and bringing it back down to the target level.
Usually, in the rebalancing process, we’re not harvesting losses. We’re harvesting our winners.
But in order to offset the gains that we have in those winning positions, we’re looking at what are other positions where we can make a swap to harvest that loss. That way, we can make that rebalancing trade and offset the gains.
Andrew Chen 24:40
For do-it-yourselfers, are there any good systems or tools besides just spreadsheets for keeping track of and helping you manage your harvesting efforts? Because you have to keep track of all your purchase dates and basis amounts to make sure you can sell at the tax-appropriate time and intentionally book a loss or a gain.
Scott Stratton 25:02
I don’t use any separate system outside of my custodian, so my accounts are held at TD Ameritrade, and they have their GainsKeeper process which shows the lot level.
I would say the other thing to consider is if you’re doing exchange-traded funds or stocks, and you have multiple purchase dates, you can go in and look at the actual lot level of those purchases. You might have an average cost basis, but you might have some shares that you purchased at a lower price or some that you purchased at a higher price.
So, when you’re doing those trades or you’re doing rebalancing, and you’re not liquidating the entire position, it does make it worth the time to go and look at what the actual cost basis is on those different lots, so you can sell the one that’s either going to give you the biggest loss or the smallest gain to realize and defer those taxes down the road even a little further.
Andrew Chen 25:49
So it sounds like nothing fancy there. Any other tips or strategies you have that investors should keep in mind when doing loss or gain harvesting, so that they harvest as effectively and efficiently as possible?
Scott Stratton 26:01
One other thing to consider is the charitable side of things. You can always donate appreciated securities. I have a number of clients who tithe or who give a substantial amount to charities, and rather than giving cash, you can donate appreciated securities.
You get the full tax write-off of the fair market value on the day of the donation, and you avoid the taxable gain. So, if you have positions that have a very large gain, rather than donating cash, you can give away those appreciated securities.
Similarly, if you’re providing funds to some children who are in college or just out of college, instead of giving them cash, you could give them the securities. And if they’re in that bracket where they’re going to be at the 0% capital gains, then they could take that money, sell the stock, get the cash, and they would pay 0% capital gains, and you would avoid paying the capital gains on that.
That’s one of the other considerations for people if they’re looking at what to do with some of these highly appreciated securities.
Andrew Chen 27:04
Interesting. Let me circle back to the charitable strategy here in a moment.
You’re saying giving some stock to, say, your children who might be in a 0% bracket, and they would sell at their 0% rate? Did I hear that correctly?
Scott Stratton 27:24
This wouldn’t be for young children because the kiddie tax would apply. This would be for your adult children who are independent and would be paying tax at their own income tax rate.
Andrew Chen 27:35
So that would be subject to gift tax rules, is that correct? It would be treated as if it was a gift?
Scott Stratton 27:43
Andrew Chen 27:45
So I guess something to keep in mind: If you’re optimizing for that, then you want to have both in mind as you plan such a gift. Is that fair to say?
Scott Stratton 27:56
Right. If you have adult children and you’re trying to use the gift tax exemption every year of giving them $15,000, or if you’re a married couple, giving $30,000 a year, rather than giving the cash, you could give appreciated securities.
It’s especially beneficial, obviously, if your kids are in that lowest tax bracket and aren’t going to pay any taxes on that. If they will pay taxes on it, they might not be so happy, but hopefully they’ll still appreciate it anyway.
Andrew Chen 28:27
On the charitable front, you donate appreciated securities to charity, you get a write-off on that, the recipient gets 100% step-up in basis to fair market value, so if they were to sell it five minutes after they received it, they wouldn’t pay taxes on that either. Is that correct?
Scott Stratton 28:47
They won’t pay any taxes because they’re a nonprofit. A charity won’t pay any income taxes on those capital gains.
Andrew Chen 28:55
I see. But it’s because of the charitable status, not because they get a step-up?
Scott Stratton 29:00
They don’t get a step-up. It’s because of the charitable status.
If you were to give to an individual, like your child, there’s no step-up in that. The step-up occurs usually just at death.
Now, one of the interesting proposals right now in Washington is to do away with the step-up in basis. That’s one of the ways that they’re looking to pay for the infrastructure bill, and instead, they would have a $1 million lifetime exemption. If you had more than $1 million of capital gains at death, your heirs would have to pay for the capital gains at that time.
Andrew Chen 29:38
That’s a proposal under the, then in effect, capital gains tax regime, or under some new tax rate structure?
Scott Stratton 29:49
There’s a couple of proposals that are going to hit people simultaneously here. If we’re looking at estate planning here, that’s where we’re going to see the biggest impact.
There’s three things that are proposed right now. They haven’t been passed, but all three would apply to estate planning.
The first is the elimination of the step-up in basis, and instead, there would be that $1 million exemption. So, if you had a $5 million estate, you might have way more than $1 million in capital gains, if you’re looking at businesses and real estate and stocks and other assets.
The second thing that we’re looking at is changing the top capital gains rate. Currently, that top rate is at 20%. The proposal in Washington right now is to take that up to 39.6% to make it the same as ordinary income.
What they say is all these billionaires, they’re getting off easy because most of their income is from capital gains, but we ought to be treating that as ordinary income. However, if you pass away and now your kids don’t have a step-up in basis, and they suddenly have $1 million or $2 million or $3 million in capital gains, they’re going to be, just for one year, in that situation of being taxed at 39.6% in capital gains.
And then the third piece of this puzzle is they’re looking at lowering the estate tax exemption. There was actually a proposal to lower it from the current $11.7 million down to $3.5 million. You put that together, and anybody who is over $3.5 million, their heirs could be paying three new taxes that they wouldn’t be paying today.
Andrew Chen 31:32
So these are the tax change proposals that are coming from the Biden administration right now. What is the likelihood that some or all of the Biden proposals actually get passed into law? Can the senate clear it when it’s divided 50/50, just through budget reconciliation?
On the face of it, it seems like they could. How should investors be setting their expectations of passage in this regard?
Scott Stratton 31:56
I’ve been looking at this, and I don’t know that I can make a bet on whether or not this is all going to be passed. However, there’s only so many ideas for how to raise new revenue, and there isn’t the stomach to raise new revenue by raising taxes on middle class people, so taxing the rich is going to be very popular, and I think these proposals will be around until they do get enacted.
I don’t know whether or not they’ll get passed here in this term, but these ideas are going to stick around until they do end up becoming reality in some format or another. I’m hoping there will be some compromise, and maybe they’ll be not as bad as it looks like now for some of my clients, but I feel like the likelihood of these getting passed in the next couple of years is probably pretty high.
Andrew Chen 32:47
What portfolio adjustments might investors potentially consider doing now to take advantage of, or just act defensively in anticipation of, any expected changes coming to the capital gains tax system? Are there any things?
Scott Stratton 33:03
I think if you’re expecting there to be higher rates, there are some things that you’ll want to do. If you think you’re going to be in that top tax bracket and your capital gains rate is going to go from 23.8% to 39.6%, or really 43.4% by the time you add in that Medicare surtax, you’ll probably want to harvest some gains now, even look at selling businesses before the end of the year, if you can.
Certainly, the other thing to remember is that the current income tax rates are set to sunset after 2025, and then will go back to some slightly higher rates. I don’t think there’s much possibility that those increases will not occur. Certainly, the government needs the revenue from how much they’re spending.
So, I do anticipate the taxes will be higher in the future, which means that right now is also a good time to be looking at Roth conversions.
Andrew Chen 33:52
More broadly, any major tax planning strategies that investors may want to potentially consider, for instance, at your end before close of tax year in order to just be as tax-efficient as possible when it comes to managing their capital gains?
For example, what are key strategies that you advise your own clients to do to ensure that they’re minimizing their tax liability when they’re evaluating their own capital gains exposure, separate and apart from the Biden proposal on changing capital gains? I’m just talking more generally.
Scott Stratton 34:26
The good news is that there is a lot that you can do to control your own taxes for the time being. Certainly, your asset location is going to be very important: choosing exchange-traded funds over mutual funds that generate capital gains.
As you’re rebalancing, if you’re adding money to the portfolio, rather than selling things and taking those gains on, look at just using your new money to go into the areas that are underweight.
Rebalancing can be both done through buying and selling, but also can be done through other means, like turning dividends on and off, so you’re reinvesting in the areas that you need to bring up, not reinvesting in areas that are already overweight, and then adding cash strategically to areas that are underweight.
And then, although asset location usually suggests that we have an efficient location in IRAs or taxable accounts for certain assets, when it comes to rebalancing, it can be a little bit helpful if you have assets in both.
If you have an emerging markets fund in a taxable account and you have an emerging markets fund in your retirement account, if it goes way up in the taxable account, you can leave it there. If it goes way down, you’ll want to harvest the loss from the taxable account. But if it does go way up, rather than selling the one that was in your taxable account, trim it from the one in the retirement account.
If you have fairly equal-sized taxable and retirement accounts, then that can also work very well to spread out the assets across both.
Andrew Chen 35:58
By the way, are there any scenarios where an asset currently at a loss, it would not make sense, in the grand scheme of things, to harvest that loss? Or do you recommend always harvesting the loss?
Scott Stratton 36:13
Perhaps if it was something illiquid, or if you were willing to hold on to that stock for 10 years and you weren’t really concerned about it.
The other thing to think about is if it was non-publicly traded. There is something called the “qualified small business stock” program. This is a program for companies that have less than $50 million in assets.
If they want to raise money, they can bring in an angel investor. And if you hold that stock for at least five years, there’s zero capital gains on it, up to 10 times your gains or $10 million, whichever is greater. This has been something that has become popular with some of these startup companies.
Andrew Chen 37:03
One thing I forgot to ask earlier, when we were talking about the charitable donations, are donor-advised funds. Can you talk a little bit about the differences between giving directly versus giving to a donor-advised fund, and when might you want to consider one over the other?
Scott Stratton 37:20
With a donor-advised fund, you’re giving the money this year, but you don’t have to give it to the net charities necessarily this year. When it goes into the donor-advised fund, you’re basically creating another account that you’re setting aside for charitable donations.
So, if you have a really big year due to the sale of a business or a huge bonus, that can be a good year to put that money aside. And then maybe you give it away to the charities over the next five or ten years or more. In this case, you get the upfront tax deduction for making that charitable donation today.
Now, one of the challenges we have in charitable giving today is that the standard deduction has gotten so large. For a married couple, $25,100, which means that if you’re only giving $25,000 a year, you’re not getting any tax deduction for it.
Last year, you could get a $300 above the line deduction. They’ve actually doubled that this year, for married couples, to a $600 deduction above the line.
But for people who are giving that $25,000 a year, you’re not really getting any tax benefit. So, if you were to say, “I’m planning to do this for the next five years,” and you put $125,000 today, you would get a nice tax deduction for that, versus if you did $25,000 a year and got zero because you’re taking the standard deduction.
Andrew Chen 28:47
That’s helpful and makes sense. Scott, I think those are all the questions I had today. Where can people find out more about you, your work, your services, etc.?
Scott Stratton 38:56
My website is goodlifewealth.com. My firm is Good Life Wealth Management, so you can look me up at goodlifewealth.com or on Facebook at Good Life Wealth.
Andrew Chen 39:07
All right. We’ll make sure we link to that in the show notes. Scott, thanks so much for talking to us today.
Scott Stratton 39:13
My pleasure. It’s been a lot of fun.
I have to say, you’ve had some really great topics in the past on tax strategies and capital gains. I think I saw ones there about 1031 exchange, asset location, home sales, tax loss harvesting, so you’ve got some great resources here for folks. Congratulations!
Andrew Chen 39:30
Cool. Thanks so much. Cheers!