Minimize Capital Gains Tax - Capital Gains Tax

When you sell an investment at a profit, you will owe capital gains taxes on the money you make. Fortunately, investors can take steps to minimize the capital gains taxes they pay and keep more of their money in their own pockets. Choosing the right kinds of investments, and choosing the right vehicles for those investments, are two ways to cut down on capital gains taxes without impacting the return on your investment.

Who has to pay estate taxes? 6 Things You Probably Didn’t Know About Tax-Loss Harvesting

For decades tax-loss harvesting was an obscure tool to minimize taxes that was only available to the ultra-wealthy. Many pundits and industry professionals who were unfamiliar with its benefits thought it couldn’t add much value. Well times have changed and now many investment management firms offer a version of tax-loss harvesting avoid capital gains tax.

Tax-loss harvesting derives its benefit from the combination of tax-rate arbitrage and the compounding of your annual tax savings. Many people mistakenly believe that tax-loss harvesting provides no benefit because you must ultimately pay a tax on the gain that results from the lowered cost basis achieved through tax-loss harvesting. What they fail to realize is the tax rate you pay on the ultimate gain is almost always lower than the rate at which you can benefit from your harvested loss. That’s because your loss creates value at the short-term capital loss rate and the ultimate gain is taxed at the much lower long-term capital gains rate.

Tax-loss harvesting is only appropriate for long-term investors. There is no benefit to tax-loss harvesting if you plan on holding your portfolio for less than one year because you cannot benefit from the aforementioned tax rate arbitrage or compounding. The annual value of tax-loss harvesting increases as your investment horizon increases because your savings continues to compound throughout. As such, tax-loss harvesting is likely more valuable to millennials who have the opportunity to save and invest for many more years than baby boomers who are close to retirement tax on capital gains.

Your benefit from tax-loss harvesting will likely increase if tax rates are raised. Again, because of tax rate arbitrage, an increase in rates at least a year before you withdraw your money from your tax-loss harvesting account will actually increase your benefit. If long-term capital gains rates increase by more than ordinary income rates (which seldom happens) then the benefit of tax-loss harvesting will decrease, but will still be substantial. The only circumstance that could significantly impact your tax-loss harvesting benefit is if rates increased in the specific year in which you planned on withdrawing all your funds.

One wash sale does not eliminate the benefits of your overall harvested losses. The wash sale rule governs whether realized losses may be used to offset ordinary income and realized capital gains. It states that you may not offset your taxes with a recognized loss if it results from the sale of a security that is replaced with a substantially identical security 30 days before or after the sale. ETF-based tax-loss harvesting services avoid the wash sale rule by replacing an ETF that trades at a loss with another ETF that is highly correlated, but tracks a different index. The IRS does not consider ETFs that track different index’s to be substantially identical avoiding capital gains.

You get more benefit from tax-loss harvesting the more frequently you add deposits to your account. Advisors not familiar with tax-loss harvesting tend to view it through their primary experience, which is with older investors who are in the wealth preservation stage of their lives. As a result these investors tend to make only one deposit when they open a new investment account. In contrast, young investors are in the wealth accumulation phase of their careers so they tend to consistently add to their investment accounts over time. The greater the number of deposits, the greater the number of tax lots with which tax-loss harvesting can work, which translates to more total annual benefit.

Tax-loss harvesting can work well even after you retire. Once again, the longer you allow your money to compound, the greater the benefit from tax-loss harvesting. It is highly unlikely that you would withdraw all your retirement savings on the date you retire. Rather you are likely to withdraw a relatively small percentage of your retirement account each year. The slower the rate at which you withdraw, the higher the annual compounded benefit from tax-loss harvesting, even accounting for the taxes due upon withdrawal.

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