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Minimize taxes by adjusting your portfolio

minimize taxesSince the markets have had some downturns lately, now could be a good time to make some adjustments to your portfolio, rebalancing and the like, that may help to minimize taxes. In doing so you can possibly get a bit of advantage in your tax bill from a loss you’ve experienced in your investments.

If you have taxable accounts, that is, accounts that are not tax-deferred (like IRAs or 401(k) plans) when you sell your investments there is capital gains treatment on your gains and losses. If you have losses and gains in your taxable account, when you realize these losses and gains by selling the holdings, your losses are subtracted from the gains, and if the result is positive (net gains), these gains are taxed at the preferable long-term capital gains rates. I say this is preferable as the rate is less, often much less, than ordinary income tax rates.

Long Term Capital Gains Tax Rates

The long term capital gains tax rates are at a maximum 15%, and at a minimum 0%. You would receive the 0% tax rate if your ordinary income tax bracket is the 10% or 15% bracket. The 15% bracket ends with taxable income of $73,800 for married couples filing jointly, or $36,900 for singles. Above this taxable income level, capital gains are taxed at the 15% rate.

Minimize taxes

When you have losses that offset your gains, your capital gains are netted against the losses, meaning that the losses are subtracted from the gains. In this manner, your gains that are offset by losses have no tax on them at all. If you have more losses than gains, your excess losses can be used to reduce your ordinary income. This can be done at a rate of up to $3,000 per year, with any remaining losses carried over to future years until they’ve been exhausted.

For example, Eddie has two mutual funds in his taxable account. He has owned both mutual funds for more than a year (necessary for long term capital gains treatment). One of the funds has had a loss of $10,000, and the other has had a gain of $5,000. If Eddie sells both fund holdings completely, he has long term capital gains of $5,000 and long term capital losses of $10,000. His net position with regard to long term capital is a loss of $5,000. So, when Eddie files his tax return for the year, he will list these two sales and the resulting net long term capital loss on the return. He will have no long-term capital gains tax, and he will be able to use $3,000 of the loss to reduce his ordinary income for the year.  The remaining $2,000 will be carried over to the following tax year, used first to reduce any long-term capital gains and secondly to reduce ordinary income.

If we turn the example around and now Eddie has had capital gains realized in the amount of $10,000 and losses of $5,000. The result is a long-term capital gain of $5,000. Since Eddie is otherwise in the 15% ordinary income tax bracket, the $5,000 long term capital gain is taxed at the 0% rate. Had Eddie been in the 25% tax bracket, his long term capital gain would be taxed at the 15% rate.

Strategies to Minimize taxes

How can you use this to your advantage? Perhaps in looking over your taxable accounts you see that you have the following:

Holding Cost Basis Current Value Gain or (Loss)
Fund A $10,000 $15,0000 $5,000
Fund B $10,000 $20,0000 $10,000
Fund C $10,000 $8,0000 ($2,000)
Fund D $10,000 $4,0000 ($6,000)

In total, you have a net long term capital gain of $7,000 ($5,000 + $10,000 – $2,000 – $6,000 = $7,000). You don’t have to sell all of these positions though, you can pick and choose what you do with your holdings. For example, if you sold your Fund A holdings (long term capital gain of $5,000) and your Fund D holdings (long term capital loss of $6,000), you would have a net long term capital loss of $1,000. If this is the only activity that you had in long term holdings for the year, you would owe no long term capital gains tax, and you would have $1,000 in long term capital losses to use to reduce your income.

That’s just one example, using the entire holding – what if you sold 80% of your Fund B holding, assuming average cost across all shares this works out to an $8,000 long term capital gain. Then you could sell 100% of both Fund C and Fund D, for a long term capital loss of $8,000. The result is zero capital gains, and zero capital gains tax.

And the options are infinite – but the method just above (zero tax, no excess against ordinary income) is the least efficient way to use your losses. When reviewing capital losses (if you have any) you should always attempt to maximize the amount that you can use against ordinary income, as this results in the greatest tax reduction for the realized loss.

So, with the above situation, you might consider selling all of Fund A, Fund C and Fund D, so that you have a resulting long-term capital loss of $3,000 ($5,000 – $2,000 – $6,000 = -$3,000). This $3,000 would be used to offset your otherwise taxable income. If you were in the 25% tax bracket, this would result in a tax reduction of $750.

The reason that you would want to sell a long-term gain holding to offset against the losses is so that you make use of the long term losses when you have them. To use an extreme example, let’s say that the gains and losses listed above in the table were all multiplied by 10. So now, for all of your holdings you have a net long-term capital gain of $70,000. At some point in the future if you sell those long term gain positions you’ll have capital gains tax owed for any net gains. If you sold everything right now, that would result in a tax of $10,500 at the 15% rate.

On the other hand, if you sold just enough of the long-term gains to offset against your long-term losses and carry over $3,000 for ordinary tax, you would still have long-term gains of $73,000 that at some point in the future may be taxed, but you have taken advantage of the situation where you have the losses in order to eliminate the tax on those holdings today. Who knows what will happen to Fund C and Fund D in the future – perhaps they will regain value and end up with gains. By selling them now and netting those losses against capital gains, you’ve taken advantage of the timing now.

Social Security and Other Tax Issues

You need to be careful about working with your capital gains. If you have a capital gain, even if it is taxed at the 0% rate, it can increase your Adjusted Gross Income (AGI) which can have the affect of increasing your taxable Social Security income (see this article for more information on how Social Security is taxed). So make sure that you project your other income tax before you undertake any capital gains activity so that you understand the complete tax impact.

Also – be careful about what you do after you’ve sold a loss position. If you intend to include that asset class position in the future, you need to wait at least 30 days before you re-purchase the same or a substantially similar asset. If you repurchase the same asset within 30 days you’ll trigger wash sale treatment to the loss, effectively eliminating that loss for tax purposes.

3 Comments

  1. Thank you clydewolf for the addition information on self employed medicare taxes.

  2. […] Jim Blankenship explains intimately how you can “Minimize Taxes by Adjusting your Portfolio” at GETTING YOUR FINANCIAL DUCKS IN A […]

  3. clydewolfNo Gravatar says:

    One other tax that can come into play courtesy of the ACA is the 3.8% tax on investment income. Households with $250,000 ($200,000 for individuals) of income may be hit with the Investment Income Tax. Investment income includes capital gains, dividends and interest.

    And for the self employed that have the incomes listed above, there is also an additional 0.9% increase in medicare tax on the amount beyond the $250,000 and $200,000 income. This is also courtesy of the ACA.

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