Use the Tax Code to Overcome Inflation and Investment Losses

One of the best ways to increase the value of your nest egg is to give a higher priority to reduce taxes on investments.

Most people don’t realize how great their investment tax burdens are or believe there isn’t much they can do about it.

Taxes often reduce investment returns more than fees do, according to research from Cliff Asness of AQR Capital Management. Yet, investors often spend more time trying to reduce fees than taxes.

After-tax returns, not pre-tax returns, are what matter more to you and your family.

Focus on investment taxes all year round. When looking at recent changes in the markets and your portfolio, consider moves that will reduce income taxes.

First, review the key basic tax rules on investments.

The sale of an investment from a taxable account generates a gain or a loss. When an asset is held for one year or less, the gain or loss is short-term. The gain or loss is long-term when the asset is held for more than one year.

Capital gains and losses are reported on Schedule D of Form 1040. On the top half of Schedule D, the short-term transactions are listed and result in either a net short-term gain or loss. On the bottom half of Schedule D, the long-term transactions are listed to arrive at a long-term net gain or loss.

Suppose after the netting process, a net short-term capital loss of $5,000 occurs and a net long-term gain of $7,000 is produced. The result is a net long-term capital gain of $2,000.

Net short-term gains are taxed as ordinary income at your regular tax rate.

Net long-term gains have the advantage of a top tax rate of 20% (23.8% if your income is high enough to trigger the 3.8% net investment income surtax). But only people with high incomes pay the 20% rate. For many people the long-term capital gains tax rate is lower, 15% or even 0%.

When there’s a net capital loss (losses exceed gains), up to $3,000 of it can be deducted against other income. Any additional net loss is carried forward to future years to be used in the same way until it is exhausted. That framework lets you implement strategies during the year to minimize taxes on investments.

Let gains run. The first strategy is to let most gains run at least until they mature into tax-advantaged long-term gains.

Since short-term capital gains are taxed as ordinary income at your highest tax rate, you need a good reason to sell before more than one year has passed.

Sometimes the investment and market fundamentals say to sell before a year has passed. Those factors should override tax considerations. But if there aren’t strong reasons for taking gains early, hold investments for more than one year.

If you use a short-term trading strategy, try to follow it in a tax-advantaged account such as an IRA instead of a taxable account.

Know your tax bracket. In 2023, the long-term capital gains tax rate is 0% for single taxpayers with taxable income up to $44,625 and for married couples filing jointly with taxable income up to $89,250. The 15% long-term gains rate applies to single taxpayers with taxable income up to $492,300 and married couples filing jointly with taxable incomes up to $553,850. Only above those income levels does the 20% maximum rate kick in.

Knowing your capital gains tax bracket could let you spot opportunities to take gains at a lower tax cost by selling in a year when you retire, lose a job, work fewer hours or business is down. Or a year with unusually large tax deductions could be a good time to take some extra capital gains.

An investment can be repurchased after selling at a gain. When you find yourself in a lower capital gains tax bracket one year or anticipate your tax bracket rising in coming years, it can be a good idea to cash in some gains at today’s lower tax rate. Then, repurchase the investment and establish the higher tax basis for it.

Know the other taxes. You should be aware of your brackets for what I call the Stealth Taxes, especially if you’re a retiree. Know whether taking an additional capital gain will increase or trigger one of these taxes or when taking a loss can reduce such taxes.

The 3.8% net investment income surtax is imposed on higher-income taxpayers. It is discussed in detail in the December 2020 issue of Retirement Watch.

Other key Stealth Taxes are the inclusion of Social Security benefits in gross income and the Medicare premium surtax, also known as IRMAA, which I’ve discussed many times. The articles are in the Archive on the members’ section of the website.

Higher adjusted gross income triggers Stealth Taxes. People often take large capital gains one year only to find they increased adjusted gross income and triggered or increased Stealth Taxes. Or they avoided taking an investment loss only to find out the loss would have reduced adjusted gross income.

Have a loss capture strategy. Investment losses are a psychological problem for many investors. They don’t want to lock in a loss and admit a mistake.

But an investment loss also is a valuable asset. After you sell, the loss is available to offset capital gains, making that portion of gains tax-free. Net capital losses up to $3,000 can be deducted against your other income. Any additional net losses can be carried forward and used in future years.

Because of the benefits, many tax advisors recommend establishing a regular policy of tax loss harvesting or loss capture. After investment prices decline, sell investments in taxable accounts that show meaningful losses, provided there aren’t high transaction costs.

After waiting more than 30 days, you can repurchase the investment. (If you don’t wait long enough, you can’t deduct the loss right away.) Or right after selling the investment you can purchase one that’s likely to benefit from a market recovery but isn’t “substantially identical.”

Recognizing a tax loss often is a better use of your capital than holding the investment until it recovers. Some investors use down markets to build a bank of capital loss carryforwards that can shelter future capital gains for years.

Don’t make gifts of assets with losses. A component of many estate plans is to give investment assets to family members. The benefits are maximized when you give the right assets.

When the family members are in lower tax brackets than you, give them appreciated assets or assets that generate income. They can sell the appreciated assets and pay lower capital gains taxes than you would have. Or they can receive income from investments and have more after-tax money to spend or reinvest than you would have.

But you don’t want to give an investment that’s selling for less than you paid. The recipient’s basis will be the lower of your cost and the current fair market value. That means no one would deduct the loss in value that occurred while you owned the asset. It is better for you to sell the asset and deduct the loss on your return. Then, you can give the sale proceeds or something else.

When giving appreciated or income-producing property to children or grandchildren, check the implications of the Kiddie Tax. That tax could make the investment income taxable at their parent’s top tax rate instead of the child’s. See our September 2018 and March 2020 issues for details about the Kiddie Tax.

Donate appreciated assets. When you’re charitably inclined, consider donating an appreciated investment instead of cash.

When you itemize deductions on your income tax return, you deduct the fair market value of the asset on the date of the gift. Neither you nor the charity will owe capital gains taxes on the appreciation that occurred while you owned the asset. The tax results are better than if you sold the asset, paid capital gains taxes, and had only the after-tax proceeds to spend or donate.

Hold some investments for life. When assets outside of tax-deferred accounts are inherited, the heir increases the tax basis to the fair market value as of the date of the previous owner’s death. No capital gains taxes are owed on the appreciation that occurred during the previous owner’s lifetime.

Since the federal estate tax doesn’t apply to most estates, a good strategy when you own investments with substantial gains is to continue holding them so the next generation can inherit and sell them without incurring any capital gains taxes.