When it comes to making tax decisions in your portfolio, you don’t want to risk a costly mistake. Given some of the counterintuitive realities regarding effective tax management, that’s a real danger. So in an effort to prevent you from falling prey to one of the common errors surrounding portfolio taxes, here are three surprising facts to keep in mind. (This article is based on Pinnacle’s new special report, “Effective Tax Policy for Managing Investment Accounts.”)
1. You really do want to pay taxes.
Let’s be honest: No-one likes to pay taxes. It’s not an enjoyable experience to have a portion of the wealth you’ve been creating extracted and sent to the government. But in the broad scheme of things, if you’re paying taxes on your investment portfolio, it’s good news. That’s because you pay taxes when your portfolio is up — when you’re making money.
While you should manage that tax impact to minimize any negative effects, the simple truth is that the more you’re paying in taxes, the more you’re creating in wealth. The single most effective way to avoid paying taxes is to lose money year after year, and you certainly don’t want to do that.
2. The benefits of tax loss harvesting are often overstated.
There is value in trying to manage tax exposure along the way, and one of the most popular ways of doing that is to harvest capital losses. Obviously, harvesting losses isn’t good news, ultimately, since it means you lost money on your investment (it’s like a consolation prize from the government for losing money). Nevertheless, investments go up and down and sometimes there are opportunities to take advantage of the declines.
The important thing to remember when you perform loss harvesting is that the technique results in a tax deferral, not a tax savings.
Imagine you have an investment you originally bought for $20,000, but which has had a bit of a pull-back and is now worth $17,000. You can sell the investment and buy a replacement security, managing the wash sale rules and claiming a $3,000 loss. However, in doing so, that new investment that you bought was purchased for $17,000, which means you’ve made your cost basis lower. As a result, if the investment ever recovers to $20,000 in the future, you’ll have a $3,000 gain. You have a $3,000 loss now and a $3,000 gain in the future, so they offset each other.
In a lot of situations, people believe that loss harvesting is creating wealth for them or saving them on taxes. Technically, that’s not the case, as every tax dollar you’re saving now will have to be paid back in the future when that investment recovers. That’s not to say that loss harvesting is worthless, but rather, that the opportunity it offers is tax deferral — that $3,000 in your pocket now (which you can invest and grow) in exchange for $3,000 paid in the future to Uncle Sam. So while there is value in tax loss harvesting, it is often exaggerated.
3. Sometimes it’s better to pay taxes early instead of deferring them.
While it’s often a good idea to defer taxes when you can, there are situations where the best thing you can do is actually pay the taxes earlier. This comes as a result of the 2013 changes in tax law which moved us from a historical two tax bracket system for capital gains — a low bracket of 5% or 0% for lower income Americans, and 15% for everyone else — to what is effectively a four bracket system today. Currently, we have 0%, 15%, 18.8% (for those also subject to the 3.8% Medicare surtax on investment income), and 23.8% (the 20% top capital gains rate combined with the 3.8% surtax).
The reason why a four bracket tax structure is so important is that if we do too good a job pushing our capital gains down the road, we could actually finish with less money. For example, imagine a portfolio that’s growing well at $50,000 a year in gains. You may think you don’t want to sell any of those gains right now, because you don’t want to pay the taxes. A $50,000 yearly gain is something you might be able to pay at the lower 15% rate, if you’re in a moderate tax bracket. However, if you push that down the road 10 years, you’ll no longer have individual $50,000 gains, but one massive $500,000 gain, which would bump you right up into the 23.8% bracket. As a result, you’ll actually pay more in taxes than you would have by simply paying at the lower rate each year.
This is a very important planning issue when you’re trying to manage portfolios on a tax efficient basis. When your income is high, then there’s little problem in deferring the taxes. But when your income is low, it may be more beneficial to harvest the gains and fill up those lower tax brackets so you can avoid being pushed into a higher tax bracket in the future.
When it comes to tax policy, there’s a balance to be found between harvesting gains and losses. Just remember that at the end of the day, you do want to pay some taxes. After all, if you’re not paying taxes, then chances are you don’t have anything to tax, and that’s a much worse situation.