This article was written by Alyssa Rausch, CPA, MBA.
As the year draws to a close it is a perfect time for investors to think about any actions they want to take with their portfolio to reduce their tax bill.
A couple of relatively simple year end tax planning strategies can be implemented by investors to lower their tax bill.
If you know that you will have significant capital gains this year, consider harvesting your tax losses by the end of the year. Tax loss harvesting is a strategy where investors evaluate their portfolio to determine which stocks have depreciated in value over the year. Then, sell the depreciated stock and recognize a capital loss which can be used to offset both capital gains and up to $3,000 for single and joint filers ($1,500 for separate filers) of ordinary income for that year.
Investors then may use the proceeds from the sale to invest in a promising stock. However if you plan to purchase a substantially identical stock, be sure to wait 30 days before or after the date of the sale to purchase the same stock to avoid being trapped by the wash sale loss rules, which could disallow your capital loss.
Analyze Your Current Investments
Investors are often left with the question as to whether or not to hold onto their stock and hope that the stock’s value goes up or whether or not to sell the stock with the thought that the stock has reached its potential. When making this decision, one consideration from a tax perspective is how long the investor has held the stock.
In cases where the investor has not already held the stock for more than one year, the investor may want to consider holding the stock until the one year period has passed. Stock held for more than one year is long term stock for tax purposes. Gains from long term stock are taxed at a lower rate than gains derived from short term stock. Long term capital gains are taxed at a 20% tax rate versus short term gains which are taxed at roughly a 40% rate, yielding a 20% tax savings from the differential in tax rates. Balancing the tax impact with the potential risk of holding onto a stock for too long resulting in the value of the stock declining is one that you will want to discuss with your financial advisor.
Also, the year that you wish to sell your investments is critical. For example, if you have net operating losses from your business activities and/or significant capital loss carryovers that can absorb the gain this year and will no longer exist next year, then you may want to consider selling your investments today and pay no tax on the gain.
In addition, if you expect to be in a lower tax bracket in future years, because you have decided to stop working and therefore will no longer received wages or self-employment income, then it may be prudent to wait to sell your investments in a year when you will be in a lower tax bracket. An additional 3.8% tax savings can result if you are able to push your income to a point where it is lower than the Net Investment Income thresholds and thereby pay little to no Net Investment Income Tax, which is a 3.8% tax applied to the lesser of your Modified Adjusted Gross Income over certain thresholds or net investment income. Bifurcating the sale of your investments into this year and next year is also a great way to lower your tax bill. By spreading the income among the two years, income will not be bunched together in the same year and thereby potentially place you in a lower tax bracket.
Plan for Future Investments
As you look ahead, there are many year end tax planning considerations as you continue to build your investment portfolio. When you are determining whether or not to invest in bonds, stocks, hedge funds or another type of investment, compare the returns of each investment vehicle on an after-tax and fee basis. For example, although tax exempt municipal bonds may yield a lower rate of return than hedge funds, when the rate of return factors in taxes and fees, you may find that your rate of return is higher by investing in tax exempt municipal bonds.
In addition, which state’s municipal bonds to purchase is an important consideration. If you choose to lend to your resident state, then any interest you receive from that bond will be tax free in your state. On the other hand, if you are in the Alternative Minimum Tax, be careful before purchasing private activity bonds, which are state and local bonds issued to provide financing for the private sector. Ask you financial advisor whether or not the bond is deemed a private activity bond.
If you are considering investing in any start-up companies, then you may want to consider investing in those companies that issue qualified small business stock (QSBS) and/or 1244 stock for a couple of reasons. Investors may exclude a portion of a gain realized on a sale of QSBS and/or defer the gain by replacing the QSBS with another QSBS if certain requirements are met. Any losses from 1244 stock may qualify to be treated as ordinary rather than capital, which is critical as your losses will be able to offset your wages and other active income without limitations. Ask the corporation if they issue these types of stock.
Investments and Gift Tax
If your goal is to gift your investments to your children and grandchildren, one way to save on your gift tax, is to gift assets today that you expect to appreciate significantly in the future, but have a low value today. All of the appreciation from the investment would entirely escape the gift tax. In addition any income derived from these investments will be taxed at your children or grandchildren’s tax rates which could result in tax savings if their tax rates are lower than yours and if they are not subject to the kiddie tax. If you would like to continue to maintain control of the investments and pay tax on the income derived from these investments and pay little to no gift tax, then you could consider putting the investments in a Grantor Retained Annuity Trust (GRAT).
Another way to reduce the overall gift tax is to utilize the net gift technique when gifting investments, where the donee agrees to pay the gift tax (as opposed to the donor). Significant tax savings results, because in this case the gift tax due is based on the amounts that the donee receives (after taxes). Given the right set of facts this could drastically reduce your gift tax bill.
Another way to reduce your tax bill is to set up a private foundation and make a charitable contribution of highly appreciated stock to the private foundation. This will serve two purposes. One you will receive a charitable deduction in the year you make the charitable contribution and thereby reduced your tax bill. Two when the private foundation sells the stock the gain will be subject to a maximum excise tax rate of 2% as opposed to 20% (if long term) or 40%(if short term) had it been sold through your personal account.
It is critical that you choose the year end tax planning strategy that best suits your investment goals. Regardless of which tax strategies you choose to pursue, be sure to coordinate with both your investment advisor and tax accountant, to ensure that all factors have been vetted.
