A key difference between tax preparation and tax planning is choice. Everyone with income has to pay taxes, but proactive taxpayers who plan ahead can have a say in how much they pay in taxes. Passive income, like capital gains and losses, provides great examples of the potential impact of a tax plan. Great financial advisors can help their clients save on taxes through both tax loss harvesting and capital gains harvesting.
[SUBSCRIBE: Get the weekly U.S. News newsletter for financial advisors. ]
Rates and Choices
The IRS gives preferential treatment to income from the sale of appreciated assets. The simplest example is realized gains on stock sales, but the rules apply to other assets including real estate and businesses. To be eligible for the preferential rates, the asset must have been held for at least one year before sale so that the gain meets the definition of a long-term capital gain. This is an important distinction as short-term capital gains and long-term capital gains are evaluated separately by the IRS come tax time.
Unlike income from working a job or operating a business, which is subject to tax as it is earned, capital gains and losses are unique in that taxpayers can choose when to recognize a taxable transaction. This means that the ups and downs of the market have no tax impact until a taxpayer chooses to make a sale. This ability to choose the timing of the taxable event creates huge opportunities.
Tax-Loss Harvesting
This opportunity to choose the timing of a taxable event is commonly taken advantage of in the form of tax-loss harvesting. This is the act of intentionally selling an investment at a loss to help offset taxable income. “Offset” is an important qualifier here because there are limits to how much loss can be recognized in a single year. If a taxpayer has no capital gains, only $3,000 of capital losses can be recognized, no matter how much other income the taxpayer has in the current year.
Unused capital losses can be carried forward to offset future gains but will not create any further tax benefit in the current year. In addition, the IRS has a wash-sale rule that restricts a taxpayer’s ability to sell a stock at a loss and then purchase the same stock or a substantially identical investment within 30 days. This may not stop tax-loss harvesting from being beneficial, but must be considered in the assessment.
While there can be tax savings from intentionally harvesting losses, it is important to understand that this is still a poor consolation prize at best. Tax-loss harvesting is often marketed as an incredible value add from financial advisors but commonly equates to losing a dollar to save some cents.
Capital-Gains Harvesting
Potentially more powerful, and subject to fewer limitations, is the less frequently used strategy of capital-gains harvesting. Some financial professionals may adamantly protest, “why would a person ever pay taxes before they absolutely have to?,” but the savvy advisor knows that getting ahead on taxes means playing the long game.
At some point taxes will come due on all income. Financial advisors who take the time to understand their clients relative tax rate, their tax rate in a given year compared to what it may be in the future, are in a great position to help their clients save on taxes.
Because capital gains are not subject to wash-sale rules, a stock could be sold and then repurchased nearly instantaneously. Although taxes may be due — in 2022 a married couple filing jointly can recognize up to $83,350 in capital gains and pay $0 in taxes if they have no other income — the client would reset their basis and limit their gains in a future tax year. With great planning, tax gains can be harvested in otherwise low income years, such as the years between retirement and social security or the required minimum distribution age, lowering the relative rates those gains are taxed at. And because wash-sale rules do not apply to gains, there is no time missed in the market.
It’s All Relative
The best tax planning is always done as a piece of understanding the larger picture. That picture needs to include a full understanding of a taxpayer’s unique tax and financial situation. Tax harvesting of any kind is something that should only be done by financial advisors who are reviewing their client’s tax returns every year and really understanding the impact their recommendations will have.
Understanding a taxpayer’s marginal tax rate, the rate they will pay on the next dollar of income, and how it will change over time is critical for tax harvesting as well. Saving client’s on their tax bill in a year where they will pay 15% in taxes is not a win if in two years they will be paying 23.8%. Great tax planning is not for the faint of heart, which is why advisors who do it well are rare and valued.
More from U.S. News
What Advisors Should Know About SLATs
6 Conferences for Financial Advisors in 2022
6 Succession Planning Tips for Financial Advisors in 2022
Advisors’ Guide to Capital Gains Taxes and Tax-Loss Harvesting originally appeared on usnews.com
