Underrated Brokerage Tax Planning Strategies
If you find a dollar on the ground, you’d excitedly pick it up.
Yet, most leave many (thousands) of dollars each year in tax savings up for grabs.
& the worst part?
They don’t even know it.
This is what it’s like to not know about:
Realizing capital gains at a 0% rate
Using specific identification to realize gains
Utilizing tax-loss harvesting
Applying asset location to your advantage
Lending against instead of selling within your brokerage
Investing through exchange traded funds > mutual funds
To understand how to not leave capital gains tax savings on the table, we’ll start from the beginning:
Understanding the difference regarding the two tax codes the IRS has for taxing income.
Ordinary income & capital gains.
Ordinary income is earned through wages, commissions, bond interest, business net income, rent, royalties, nonqualified dividends, and short-term capital gains.
Ordinary tax brackets are progressive and tiered:
Progressive meaning, as you earn more money, you pay more taxes.
Tiered meaning, each level = new tax rate (this isn’t a flat tax).
If you’re married and have $200,000 of ordinary income in 2022, your next dollar of income is taxed at 24%.
But you don’t pay 24% tax on the whole $200,000.
After you take out the standard deduction of $25,900 (2022 figure) to get to taxable income, your effective tax rate is a blend of the 10%, 12%, 22%, and 24% brackets (both progressive & tiered).
On the other hand, anytime you sell for an asset with a profit motive, you have a capital gain.
This could be a real estate investment property or taxable gain in your brokerage account.
If you hold your asset for less than one year, you’re taxed at your marginal ordinary income tax rates (discussed above).
If you hold your asset for longer than one year, you qualify for long term capital gains rates.
Long term capital gains > short term capital gains
Reason being long term capital gains rates are lower.
Capital gain rates are split into 3 brackets: 0%, 15%, and 20%.
What capital gain tax you pay, depends on your taxable income.
For the 2022 tax year those income thresholds are as follows:
Note: the actual tax brackets are the same as ordinary brackets, but the tax rate is lower
Taxable income is after the standard or itemized deduction (line 15 of your 1040):
Capital gains (which come through on line 7) stack on top of your ordinary income.
There are a few exceptions to the capital gains rules:
If you sell a home & you’ve lived in the home for at least 2 of the last 5 years, $250,000 of the gain (if filing single) & $500,000 of the gain (if filing married joint) is excluded from being taxed.
Collectables (art, antiques, stamps, wines, gems, etc.) are taxed at 28%.
If you sell an investment property that you depreciated, you must recapture the depreciation at 25% (this is in addition to the capital gain).
Realizing capital gains at a 0% rate
Taxable income permitting, realizing capital gains at a 0% rate is one of the more underutilized tax planning strategies available today.
As capital gains stack on top of ordinary income, if a married filing joint tax filer has $60,000 of taxable income this means they have $23,350 of room to realize capital gains at a 0% rate.
If you have $0 in taxable income you can realize $83,350 of gain without paying tax.
Harvest your capital gains up to the 12% bracket to realize gains at a 0% rate.
It’s important to note that your gain is not the total market value of securities sold.
If you sell $50,000 of stock in your brokerage, you’re not paying $50,000 in capital gains.
You pay capital gains on the growth above what you contributed (AKA your cost basis).
For some this could be $49,000, for others, $1,000.
Each time you purchase securities that represents a tax lot.
Looking under the hood of the $50,000 of gain, is it likely made up of a variety of tax lots that equate to the total market value of $50,000.
This brings us to tax tip #2 - specific identification.
Using Specific Identification
When you look under the hood of your $50,000 of marketable securities, you’ll find a list of all the dates you purchased the security, at what price, quantity, and market value.
If you systematically made $2,000/mo contributions then over the course of 2 years, you would have 25 tax lots.
When you sell, specify the tax lots that offer the lowest realized capital gain.
If you do not utilize specific identification and sell without consideration of cost basis you’re likely guaranteeing yourself to pay higher tax as default capital gain realization methods are usually First In, First Out (FIFO) or Last In, First Out (LIFO).
With FIFO realization you’re likely realizing gains at short-term rates (ordinary rates) resulting in a higher tax bill.
With LIFO realization you’re likely realizing gains with the highest embedded gains (lowest cost basis) resulting in a higher tax bill.
Using specific identification offers more control over how your realized gain is taxed.
Specific identification alone could save you a couple hundred or thousand dollars in taxes.
Tax-Loss Harvesting
Tax loss harvesting uses market volatility to your advantage through capturing losses that are passed through on your tax return to offset income.
Just as when you can sell in your brokerage account for a gain, you can also sell for a loss.
When you sell for a loss that loss is deductible against your income in the year you incurred the loss.
If you own $50,000 of a small-cap fund and you sell your position for $30,000, that $20,000 loss is tax-deductible.
Just as the character (long term or short term) matters for gains, the same applies for losses.
If you have a short term (less than 1-year holding period) loss, that loss is classified as an ordinary loss.
If you have a long term (longer than 1-year holding period) loss, that loss is classified as a capital loss.
With a mix of ordinary and capital losses throughout the year, how is the net loss calculated?
First, you net:
Short term losses with short term gains.
&
Long term losses with long term gains.
What’s left is one of four options:
Net short term capital loss
Net short term capital gain
Net long term capital loss
Net long term capital loss
After you’ve netted short and long term losses, you net those gains/loses once more to get a final loss or gain.
Unless:
If you’re left with a short term capital gain and a long term capital gain, in this case, you will pay tax at your ordinary (for short term) and capital gain (for long term) tax rate.
Let’s consider an example:
$2,000 short term capital loss
$3,000 short term capital gain
$6,000 long term capital loss
$1,000 long term capital gain
Netting short term capital gains = $1,000 short term capital gain
Netting long term capital gains = $5,000 long term capital loss
Then you net losses once more to arrive at a net long term capital loss of $4,000.
As you can realize $3,000 in capital loss each year, you would have a $3,000 capital loss to offset ordinary income.
Your $1,000 long term capital loss would be carried forward indefinitely to future tax years.
When you carry over a loss, the loss retains its original character as either long term or short term (in this case long term).
As you’re looking to harvest losses, it’s important to be wary of the wash sale rules.
Wash sale rules state investors who repurchase any stock sold for a loss within 30 days (before or after) the capital loss cannot deduct the loss.
Instead, it is added to the purchase price of the security that broke the wash sale rules.
An example of how to avoid the wash sale rule would be:
You sell a Vanguard S&P 500 ETF to realize a loss.
Instead of buying the same Vanguard S&P 500 ETF ($VOO), you purchase SPDR S&P 500 ETF ($SPY).
This way, you don’t lose your loss tax benefits from breaking the wash sale rules and you still are able to keep your asset allocation intact.
There are many other benefits & tax tips to having a brokerage account:
Using a securities backed line of credit to loan against the portfolio (to access liquidity without realizing capital gains).
Brokerage accounts have no contribution limits & no penalty for early distribution
Upon your passing, the assets receive a step to fair market value so heirs can sell at $0 gain.
Ex: $2,000,000 brokerage with $1,200,000 of basis. At death, the basis is stepped up to $2,000,000 and you can realize the total market value without tax consequence.
Given mutual funds are required to distribute capital gains to shareholders at year end, use exchange traded funds (ETFs) to reduce the possibility of capital gain distributions in your brokerage (which generate additional capital gain taxes).
Keep tax inefficient asset classes - such as high yield bonds or real estate investment trusts (REITs) in tax-deferred accounts (IRAs, 401k, etc.) so you’re not incurring a tax consequence each year.
Don’t sleep on a taxable account to build wealth.