Simple Strategies to Reduce Taxes

Posted By: Advisor Analyzer Team

While there are many types of taxes individuals pay on wages, properties, gifts, etc… the most applicable taxes for investors are income and capital gains tax. When investors examine their portfolio performance, they often neglect the impact that taxes have on their overall return. Returns can vary tremendously depending on the asset and the holding period. Below are some strategies that may not directly increase your investment’s returns but can reduce the amount owed to Uncle Sam, but first a brief overview on the how your investments are taxed.

Income and Capital Gains

The IRS makes a distinction between payments received via dividends or interest versus returns from appreciation. The taxable amount depends on the investor’s ordinary income tax rate, (but is currently capped at 15% until 2010). Dividends and interest received from stock and bond positions are not categorized as capital gains, but as income and taxed as ordinary income.

Capital gains are not considered a part of income and applicable when the investor realizes a gain. Therefore, an individual who purchased a share of stock at $1 which is now worth $10 will not be liable for capital gains tax, until they sell the position. At that point, the difference between the selling price and the purchase price (A.K.A cost basis) is subject to capital gains taxes. However, the investor has the ability to offset those gains with losses that were realized in the same year.

Short Term and Long Term Capital Gains

The IRS makes a further distinction on capital gains that is categorized by the length of time a position was held. Generally, an investment that is held for longer than a year is subject to long term capital gains, while those that are held less than a year are considered short term. Short term gains are taxable at the investor’s ordinary income rate, while long term capital gains are often lower (15% until 2010).

Tax Lot Management

For anyone who’s ever purchased a position and made subsequent contributions to that same investment, tax lot management is an important and applicable strategy to reduce their tax liability. Tax lot management is a strategy where an individual identifies a specific lot of stock to sell for the purpose of minimizing the capital gains taxes owed.

Suppose an investor with an ordinary income tax rate of 25% purchased stock XYZ on three separate occasions: 100 shares two years ago, 100 shares one year ago, and 100 shares yesterday. The individual decides to rebalance his portfolio and would like to sell half of his position (150 Shares) in XYZ. Since he has purchased the XYZ on different dates, he is able to select which lot to sell and which to hold. If the investor sells the position he purchased yesterday (i.e. last in first out), there will be a short term capital gain tax applied at his ordinary income rate. However, if the investor chooses to sell the lot from two years ago and half the lot from last year, they are both subject to long term capital gains taxes which results in lower taxes paid.

Extending Holding Period

Another alternative for investors is to extend the holding period of an asset. Suppose our fictitious investor purchased and held ABC stock for 11 months and would like to sell the position. If the investor waits one more month, the short term capital gains which would be taxed at the ordinary income rate now convert to long term capital gains, and would be taxed a lower 15% rate (vs. 25%). Therefore, depending on the investor’s perception of the stock price move, he may be better off delaying the sale for another month. If the stock were to decrease 5%, the benefit from the tax reduction more than offsets the depreciation of the stock. However, if the investor feels the stock will decline 20%, he may be better off realizing a short term capital gain rather than a long term loss.

Tax Loss Harvesting

Tax loss harvesting is the deliberate realization of a capital loss to offset a tax liability that results from a capital gain in another position. The realized loss may offset the capital gains for that year and any residual losses are carried forward to subsequent periods. However, there is a $3,000 annual limit on the loss carry forward in any given year.

Suppose our investor has realized gains in his XYZ position of $100, and unrealized losses in his ABC position of $90. The investor feels ABC will perform well much later in the future, but has no upside potential for the next year. Rather than simply holding ABC and paying taxes on his XYZ position, the investor can sell his ABC position to realize the $90 loss and offset the $100 XYZ gain. Now the investor’s taxable capital gains is $10 rather than $100. Given the individual did not purchase ABC in the past 30 days or the next 30 (wash sale rule) the investor can repurchase ABC and wait for the stock to appreciate over the next two year frame. Note: if the investor fails to satisfy the wash sale rule, the cost basis for ABC may be readjusted downward creating a larger taxable event when he sells it in the future.

Conclusion

While there are other strategies that an investor have at their disposal to minimize the impact of tax liabilities, these three are the simplest methods available to most investors. All investors should be aware of how taxes can impact their net portfolio returns and exercise some form of tax minimization strategies. While they may not be as exciting doubling your money in the market, a penny saved is always a penny earned.