Three Tips to Temper Taxes

Oct. 6, 2021

Calming concerns about potential tax increases can be challenging when the details remain unclear. So how can you deal with their worries during this time of uncertainty? Focus on what you can control today.

What You Can Do Now

Investing with an eye on taxes is an ongoing effort. It’s important to regularly review specific situations and long-term goals and be on the lookout for opportunities to take advantage of important tax-mitigating moves throughout the year.

Consider three strategies that may improve the overall tax efficiency of your clients’ portfolios, regardless of prevailing tax rates.

Key Takeaways

  1. Harvest Tax Losses - In some cases, you may be able to turn investment losses into strategic wins for your clients. Using losses to offset gains may result in a lower tax bill.

  2. Manage Capital Gains and Dividends - Managing capital gains and dividend distributions, from holding periods to ex-dividend dates, can potentially help enhance a portfolio’s tax efficiency.

  3. Plan Investments Strategically - Focusing on tax-friendly investments—and implementing strategies and tactics designed to reduce the portfolio’s tax liability—helps keep tax efficiency at the forefront all year long.

Harvest Tax Losses

While losses are never the goal, losing money in an investment can sometimes have an upside. With a tax-loss harvesting strategy, investment losses in one or more investments can help offset gains in others, which may result in a lower overall tax liability. Investors can use their realized losses to offset capital gains or ordinary income, up to $3,000 in a single year for joint filers ($1,500 for single filers), according to the Internal Revenue Service (IRS). Investors may carry forward any additional losses indefinitely. Figure 1 provides a hypothetical example of how the strategy works.

Figure 1 | Tax-Loss Harvesting: A Hypothetical Example

This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities.

  • The hypothetical long-term loss from the sale of XYZ partially offsets the long-term gain from the sale of ABC.

  • This example assumes a capital gains tax rate of 15%. This rate varies by filing status and income.

  • The offsetting loss results in a tax savings of $600.

When using the tax-loss harvesting strategy, it’s important to keep a few things in mind:

  • Be mindful of the wash sale rule. This IRS rule prohibits the purchase of the same or “substantially identical” security within 30 days (before or after) of selling that security at a loss. You also may not sell a security at a loss in a taxable account and purchase that same security for a tax-deferred account within 30 days of the sale. However, you may purchase a similar investment to maintain exposure to that industry or sector.

  • Know your alternatives. Consider the relative advantages and disadvantages of using ETFs, active mutual funds or indexed mutual funds to replace a security sold at a loss.

  • Don’t let taxes alone drive the sell decision. Before harvesting tax losses, make sure the sale makes sense for the overall investment strategy and client goals.

  • Use for taxable accounts only. There’s no benefit to harvesting losses in a tax-deferred account.

Manage Capital Gains and Dividends

Monitoring distribution timelines and investment holding periods—and determining if or when to buy or sell specific assets—are important components of a comprehensive investment strategy. These planning efforts can make a big difference in the portfolio’s yearly tax bill.

Regarding capital gains, the holding period is crucial. How long your client owns an investment before selling it at a profit will determine the tax liability. Selling an investment owned for less than one year triggers a short-term capital gain, while exiting an asset owned for more than a year causes a long-term capital gain.

In general, long-term capital gains receive more favorable tax treatment than short-term gains, which are taxed as ordinary income at marginal rates as high as 37%. The maximum tax rate for long-term capital gains is 20% (see Figure 2).

Figure 2 | Long-Term Gains Get Favorable Tax Treatment

Long-Term Capital Annual Inc Married Filing Jt Annual Inc Single Taxpayer

Gains Tax Rate

0% $0 to $80,000 $0 to $40,000

15% $80,001 to $496,600 $40,001 to $441,450

20% More than $496,600 More than $441,450

Similarly, dividends receive different tax treatment depending on their classification. Qualified dividends are taxed at the same rates as long-term capital gains. Nonqualified dividends are treated as ordinary income for tax purposes, taxed at regular income tax rates of 10%, 12%, 22%, 24%, 32%, 35% or 37%. To be qualified, a dividend:

  • Must be paid by a U.S. corporation or qualified foreign entity.

  • Cannot consist of premiums or insurance kickbacks, annual distributi