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tax strategy and investment strategy

Everyone hates to pay more in taxes. But this is something that has to be done. Sometimes taxes can often lead investors to make foolish investment decisions. The stock market bottomed in March 2009 and since then we have experienced the second-longest bull market rally of all time. This type of market environment typically creates a stockpile of unrealized gains in the equity portion of your portfolio. When you go to sell one of your investment holdings that has appreciated in value over the past few years there may be a big tax bill waiting for you. But when is it the right time to ignore the tax hit and execute the trade?

Do The Math

What sounds worse? Writing a check to the government for $10,000 in taxes or experiencing a 3% loss in your investment accounts? Most people would answer paying taxes. After all, who wants to write a check to the government for $10,000 after you have already paid your fair share of taxes throughout the year. It’s this exact situation that gets investors in a lot of trouble when the stock market turns or when that concentrated stock position takes a nosedive.

Before making this decision make sure you do the math. If you have $500,000 in your taxable investment account and the account value drops by 3%, your account just lost $15,000. It would have been better to sell the holding, pay the $10,000 in taxes, and you would still be ahead by $5,000. Before making the decision not to sell for tax reasons, make sure you run this calculation.

Gains Are Good

While most of us run from paying taxes like the plague, remember gains are good. It means that you made money on the investment.  At some point you are going to have to pay tax on that gain unless your purposefully waiting for the investment to lose value or if you plan to die with that holding in your estate.

If you put $100,000 in an aggressive investment a year ago and it’s now worth $200,000, if you sell it all today, you will have to pay long term cap gains tax and possibly state tax on the $100,000 realized gain. But remember, what goes up by 100% can also go down by 100%. To avoid the tax bill, you make the decision to just sit on the investment and 3 months from now the economy goes into a recession. The value of that investment drops to $125,000 and you sell it before things get worse. While you successfully decreased your tax liability, the tax hit would have been a lot better than saying goodbye to $75,000.

As financial planners we are always looking for ways to reduce the tax bill for our clients but sometimes paying taxes is unavoidable. The more you make, the more you pay in taxes. In most tax years, investors try to use investment losses to help offset some of the realized taxable gains. However, since most assets classes have appreciated in value over the last few years, investors may be challenges to find investment losses in their accounts.

Capital Gains Tax

A quick recap of capital gains tax rates. There are long-term and short-term capital gains. They apply to investments that are held in non-retirement account. IRA’s, 401(k), and 403(b) plans are all tax deferred vehicles so you do not have worry about realizing capital gains tax when you sell a holding within those types of accounts.

In a taxable brokerage account, if you buy an investment and sell it in less than 12 months, if it made money, you realize a short-term capital gain. Short-term gains do not receive preferential tax treatment. You pay tax at the ordinary income tax rates.

However, if you buy an investment and hold it for more than a year before selling it, the gain is taxed at the preferential long-term capital gain rates. At the federal level, there are three flat rates: 0%, 15%, and 20%. At the state level, it varies based on what state you live in. If you live in New York, where we are headquartered, long-term capital gains do not have preferential tax treatment for state income tax purposes. They are taxed as ordinary income. While other states like Alaska, Florida, and Texas assess no taxes at the state level on capital gains.

The tax rate that you pay on your long-term capital gains at the federal level depends on your AGI for that particular tax year. Here are the thresholds for 2018:

long term cap gains rates

A special note for investors that fall in the 20% category, in addition to being taxed at the higher rate, there is also a 3.8% Medicare surtax that is tacked onto the 20% rate. So the top long-term capital gains rate for high income earners is really 23.8%, not 20%.

Don’t Forget About The Flat Rate

Investors forget that long-term capital gains are taxed for the most part at a flat rate. If your AGI is $200,000 and you are considering selling an investment that would cause you to incur a $100,000 long-term capital gain, it may not matter from a tax standpoint whether you sell it all this year or if you split the gain between two different tax years. You are still taxed at that flat 15% federal tax rate on the full amount of the gain regardless of when you sell it.

There are of course exceptions to this rule. Here is a list of some of the exceptions that you need to aware of:

  • Your AGI limit for the year
  • The impact of the long-term capital gain on your AGI
  • College financial aid
  • Social security taxation
  • Health insurance through the exchange

First exception is the one-time income event that pushes your income dramatically higher for the year. This could be a big bonus, a good year for the company that you own, or you sell an investment property. In these cases you have to mindful of the federal capital gains tax thresholds. If it’s toward the end of the year and you are thinking about selling an investment that has a good size unrealized gain built up into it, it may be prudent to sell enough to keep yourself out of the top long-term capital gains bracket and then sell the rest in January when you enter the new tax year. That move could save you 8.8% in taxes on the realized gains. The 23.8% to tax rate minus the 15% median rate. If you are at the beginning or in the middle of a tax year trying to make this decision, the decision is more difficult. You will have to weigh the risk of the investment losing value before you flip into a new tax year versus paying a slightly higher tax rate on the gain.

To piggyback on the first exception, you have to remember that long term capital gains increase your AGI. If you make $300,000 and you realize a $200,000 long term capital gain on an investment, it’s going to bump you up into the highest federal long term capital gains tax rate.

College financial aid can be a big exception. If you have a child in college or a child that will be going to college within the next two years, and you expect to receive some type of financial aid based on income, be very careful about when you realize capital gains in your investment portfolio. The parent’s investment income can count against a student’s financial aid package. Also, FASFA looks back two years for purposes of determining your financial aid package so conducing this tax versus risk analysis requires some advanced planning.

For those receiving social security benefit, capital gains can impact how much of your social security benefit is subject to taxation.

For individuals that receive their health insurance through a state exchange platform (Obamacare) and qualify for income subsidies, the capital gains income could decrease the amount of the subsidy that you are receive for that year. Be careful.

Don’t Make The This Mistake

Bottom line, nothing is ever simple. I wish I could say that in all instances you should completely ignore the tax ramifications and make the right investment decision. In the real world, it’s about determining the balance between the two. It’s about doing the math to better under the tax hit versus the downside risk of continuing to hold a security to avoid paying taxes.

While the current economic expansion may still have further to go, we are probably closer to the end than we are the beginning of the current economic expansion. When the expansion ends, investors are going to be tempted to hold onto certain investments within their portfolio longer than they should because they don’t want to take the tax hit. Don’t make this mistake. If you have a stock holding within your portfolio and it drops significantly in value, you may not have the time horizon needed to wait for that investment to bounce back. Or you may have the opportunity to preserve principal during the next market downturn and buy back that same investment at lower level.

In general, it’s good time for investors to revisit their investment portfolios from a risk standpoint. You may be faced with some difficult investment decisions within the next few years. Remember, selling an investment that has lost money is ten times easier than selling one of your “big winners”. Do the math, don’t get emotionally attached to any particular investment, and be prepared to make investment changes to your investment portfolios as we enter the later stages of this economic cycle.

Michael Ruger

About Michael………

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

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Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.