Taxes. We all pay them, no matter where we fall on the spectrum of income or political views. The IRS levies many taxes such as sales or income taxes, the timing over which we have no control. But the timing of other tax payments like capital gains taxes is in our power, and exercising that control can pay dividends. When we sell an asset for more than the cost, the difference is the capital gain.
Avoid capital gains
You can avoid capital gains taxes in three scenarios.
The first, applicable to most workers, is to utilize retirement accounts. Investors fund tax-deferred accounts like a 401(k) or an IRA with pre-tax dollars. In exchange, the IRS taxes any withdrawals at higher ordinary income tax rates. Investors fund Roth 401(k) or Roth IRA accounts with after-tax dollars, so withdrawals are not taxed. The similarity of these accounts is that they all offer tax-free growth, avoiding capital gains on sales.
The second is to give your assets away to a charitable organization. By carrying not-for-profit status, these organizations will not be liable to pay taxes on any realized gains. Utilizing a Donor Advised Fund can be a tool to achieve these ends if you support multiple organizations or prefer to spread your giving over time.
The third is to die, at which point the cost basis of your assets will be stepped up to the current market value, either at the date of death or six months later as determined by the executor, eliminating any unrealized gains for your beneficiaries. Incorporating your death into tax planning should not be an overarching plan, but aggregate circumstances might present conditions that make sense for certain assets.
Use a Separately Managed Account
Separately managed accounts (SMA) hold many benefits, including tax management. Unlike investing in a mutual fund, or exchange-traded fund, investing through an SMA provides direct ownership of your securities. By doing so, you can decide when to take capital gains based on your tax situation. Even better, you can choose to take any available capital losses as offsets. If you have an asset with an unrealized loss, but you would like to hold it for the long-term, you can sell the asset now to realize the loss and repurchase it later. But wait at least 30 days, the minimum time required by the IRS to allow the application of the loss against gains.
Develop a capital gains budget
As with a spending plan, you can create a capital gains plan. Say you have a portfolio valued at $1,000,000 with $500,000 of unrealized gains. Then imagine you or a new investment manager want to adjust the portfolio. Taking those gains is not an all-or-nothing decision. You could decide to realize $100,000 in capital gains over each of the next five years or $50,000 over the next ten. Determine the amount and time frame that suits your needs and objectives.
Try to avoid realizing capital gains on assets held less than 12 months. These are short-term gains taxed as ordinary income. In most cases, these tax rates will be much higher than long-term capital gain rates.
Capital gains taxes have been around since 1913. At first, they were set at the same rates as ordinary income but were separated starting in 1922:
Given the fiscal policy extended to help address the economic fallout from a COVID-19 driven recession and the possibility for more, taxes of all kinds are likely to go up, including those for capital gains. At 20%, current maximum capital gains rates are among the lowest since their introduction. It makes sense to consider taking some capital gains now and paying taxes at a lower rate.
Focus on taxes where you control the timing and amount, managing them to suit your situation.
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