Many financial planners may be selling some U.S. stocks these days, either to reflect caution as major equity indexes reach record highs or to rebalance portfolios by thinning overweight positions.
Yet after a six-year bull market, many clients hold appreciated equities, so sales trigger taxable gains. With the top tax rate on long-term capital gains at 20% (up from 15%), in addition to the 3.8% surtax on net investment income for wealthier investors, taking gains can even be more taxing.
How can advisors sell stocks and avoid a painful tax bite?
“The obvious technique is to balance gains with losses in the portfolio,” says Malcolm Makin, president of Professional Planning Group of Westerly, R.I. By now, though, investors might not have many losses left from the 2008-09 crash.
“Most of the loss carryforwards from prior tax returns after the recession are about used up,” says Sue Stevens, an advisor in Deerfield, Ill.
Advisors suggest a variety of other ways to take losses as well as gains.
“We utilize a rebalancing tool that uses algorithms to come up with the most tax-efficient way to rebalance or get out of positions,” says Lance Gunkel, chief operating officer at Sherpa Investment Management in West Des Moines, Iowa. “In the current environment, this may mean taking offsetting losses in other asset classes, such as emerging markets debt and international equity.”
In the wake of plunging oil prices, energy stocks and funds might offer capital losses. Up to $3,000 of any losses that exceed gains in a calendar year can be deducted from other income, while remaining losses can be carried over to offset gains taken in the future.
J. Michael Martin, chairman and chief investment officer at FAI Wealth Management in Columbia, Md., says his firm vows to avoid letting taxes drive its investment policy. “However,” he adds, “the one thing we can do is make sure we harvest any unrealized losses to offset the gains we take when we trim. Most of our equity exposure is in individual stocks rather than market ETFs, so we have ongoing opportunities for tax minimization.”
Ginny Stanley, a principal with CPA and advisory firm REDW in Albuquerque, N.M., says she reminds clients that paying tax is not always a bad thing. “At least paying tax assumes you are headed in the right direction,” she says. “Taking gains now can be healthy if the client believes the capital gains tax will increase in the future. Having said that,” she adds, “we try to minimize tax consequences through the timing of gains and losses, taking advantage of year-to-year fluctuations in client income, and planning for retirement distributions in a way that can minimize tax.”
Stanley says her firm uses several tactics to reduce positions while avoiding steep taxes. “They include selective rebalancing, asset location strategies and increased use of passive investments,” she says. “We review rebalancing reports on a quarterly basis and are isolating sales of stocks that have smaller gains or focusing on assets in tax-deferred accounts.” If appreciated stocks are sold in a tax-advantaged account like an IRA, there is no immediate tax impact.
More broadly, the firm chooses which asset classes belong in taxable vs. tax-advantaged accounts to minimize ordinary income and capital gains. “In addition,” Stanley says, “our increased use of passive investments has helped to minimize the large capital gain distributions that are usually incurred with actively managed funds.”
Another common tactic involves charitable contributions. “Clients can donate highly appreciated shares to a charity or to a donor-advised fund,” Stevens says. “We are seeing more of this as people feel comfortable that they have enough for their lifetimes.”
As long as the shares have been held longer than one year, the donor can get a tax deduction for the full market value. (Of course, deductions are most valuable for people with high effective tax rates.) Cash that otherwise would be donated can be retained and the capital gains tax obligation essentially disappears.
With some sophisticated techniques like charitable remainder trusts and charitable gift annuities, contributing appreciated shares may provide a substantial upfront tax deduction, income tax deferral and extended cash flow to the donor. “Donating highly appreciated stocks or mutual funds is a great way to avoid paying tax on the sale of those assets,” says Stanley.
Stevens also focuses on approaching retirement distributions with an eye toward minimizing taxes. “One tactic I’ve been using lately,” she says, “is doing 15-year tax projections for clients in early retirement. There may be opportunities to take IRA distributions or do Roth conversions in years when taxable income is low. They also can recognize significant capital gains.
“I’ve done that with several clients who still paid almost no tax because they were still under age 70 ½, when required minimum distributions must start,” she adds. “We were able to shift paying taxes from a higher bracket (after age 70 ½) to a lower bracket now and rebalance the portfolio by taking capital gains from highly appreciated assets.”
She spells out an example: a retired couple in their early 60s with little or no earned income. Stevens’ firm might run 15-year tax projections, taking them into the time when they will take RMDs.
If their investment strategy indicates they should trim U.S. equities, the couple might be able to take some capital gains now on highly appreciated stocks and owe nothing in tax, depending on their income. Even if they owe 15% on some or all of the gains, their current income (without RMDs) may still be low enough that they’ll avoid the 3.8% surtax and other tax code pitfalls.
Nick Defenthaler, a planner at the Center for Financial Planning in Southfield, Mich., mentions a similar tax tactic for investors with modest income. “One planning tool we’ve been using recently is ‘gain harvesting’ for clients who are in the 15% tax bracket,” he says. “Depending on income, someone could sell an appreciated security, realize the gain and pay zero dollars in tax.”
In 2015, the 15% tax bracket goes up to $37,450 of taxable income for single filers and to $74,900 on a joint tax return. Those taxable income numbers are after deductions, so a married couple could have gross income of $80,000 or $90,000 or more and still be in the 15% bracket — which is a 0% bracket for long-term capital gains.
That 15% bracket could include retirees who have not yet begun to receive Social Security benefits or young adults starting their careers who receive gifts of appreciated securities from their parents, Defenthaler says. The youngsters may be able to sell the shares and owe no tax on the reported gains.
“A taxpayer who is in the 15% bracket can literally repurchase the security the next day to reset the cost basis,” Defenthaler says; wash-sale rules apply only to losses, not gains.
“The client pays no tax on the sale and now has the same fund, with virtually the same balance but with zero unrealized gain attached to it,” he adds. “Clients sometimes look at us in wonder and think gain harvesting is almost too good to be true. In reality, it’s just proactive tax planning done well.”
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.
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