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Despite No Changes in Tax Law, It’s Still a Good Time to Craft a Strategy

By Contributor December 21, 2023

Planning Is Key

By Kristina D. Houghton, CPA

Surprisingly, 2023 was a year with no tax-law changes. Congressional members of both parties introduced major tax policy legislation, but so far, most of those bills were partisan. For Congress to pass tax legislation, it will need to be the product of bipartisan compromise. Any tax-policy legislation should also adhere to core values of fostering domestic economic growth, providing support for workers and their families, and prioritizing fiscal responsibility.

Despite the lack of legislation, year-end is still the optimal time for tax planning. But you must be careful to avoid potential pitfalls along the way.

We have prepared the following 2023 year-end tax article divided into three sections:

• Individual Tax Planning;

• Business Tax Planning; and

• Financial Tax Planning.

Be aware that the concepts discussed in this article are intended to provide only a general overview of year-end tax planning. It is recommended that you review your personal situation with a tax professional.

“If you come out ahead by itemizing, you may want to accelerate certain deductible expenses into 2023.”

INDIVIDUAL TAX PLANNING

Itemized Deductions

When you file your personal 2023 tax return, you must choose between the standard deduction and itemized deductions. The standard deduction for 2023 is $13,850 for single filers and $27,700 for joint filers. (An additional $1,850 standard deduction is allowed for a taxpayer age 65 or older.)

YEAR-END MOVE: If you come out ahead by itemizing, you may want to accelerate certain deductible expenses into 2023. For example, consider the following possibilities:

• Donate cash or property to a qualified charitable organization.

• Pay deductible mortgage interest if it otherwise makes sense for your situation. Currently, this includes interest on acquisition debt of up to $750,000 for your principal residence and one other home, combined.

• Make state and local tax (SALT) payments up to the annual SALT deduction limit of $10,000.

Charitable Donations

The tax law allows you to deduct charitable donations within generous limits if you meet certain record-keeping requirements.

YEAR-END MOVE: Step up charitable gift giving before Jan. 1. As long as you make a donation in 2023, it is deductible in 2023, even if you charge it in 2023 and pay it in 2024.

• If you make monetary contributions, your deduction is limited to 60% of your adjusted gross income (AGI). Any excess above the 60%-of-AGI limit may be carried over for up to five years.

• If you donate appreciated property held longer than one year (i.e., it would qualify for long-term capital-gain treatment if sold), you can generally deduct an amount equal to the property’s fair market value (FMV) on the donation date, up to 30% of your AGI. But the deduction for short-term capital-gain property is limited to your initial cost.

Higher-education Credits

The tax law provides tax breaks to parents of children in college, subject to certain limits. This often includes a choice between one of two higher-education credits.

YEAR-END MOVE: When appropriate, pay qualified expenses for next semester by the end of this year. Generally, the costs will be eligible for a credit in 2023, even if the semester does not begin until 2024.

Typically, you can claim either the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Credit (LLC), but not both. The maximum AOTC of $2,500 is available for qualified expenses for four years of study for each student, while the maximum $2,000 LLC is claimed on a per-family basis for all years of study. Thus, the AOTC is usually preferable to the LLC.

Both credits are phased out based on your modified adjusted gross income (MAGI). The phase-out for each credit occurs between $80,000 and $90,000 of MAGI for single filers and between $160,000 and $180,000 of MAGI for joint filers.

TIP: The list of qualified expenses includes tuition, books, fees, equipment, computers, etc., but not room and board.

Miscellaneous

• Install energy-saving devices at home that result in either of two residential credits. For example, you may be able to claim a credit for installing solar panels. Generally, each credit equals 30% of the cost of qualified expenses, subject to certain limits.

• Avoid an estimated tax penalty by qualifying for a safe-harbor exception. Generally, a penalty will not be imposed if you pay 90% of your current year’s tax liability or 100% of your prior year’s tax liability (110% if your AGI exceeded $150,000).

• Empty out flexible spending accounts for healthcare or dependent-care expenses if you will forfeit unused funds under the ‘use it or lose it’ rule. However, your employer’s plan may provide a carry-over to 2024 of up to $610 of unused funds or a two-and-a-half-month grace period.

BUSINESS TAX PLANNING

Depreciation-based Deductions

As the year draws to a close, a business may benefit from one or more of three depreciation-based tax breaks: the Section 179 deduction, first-year ‘bonus’ depreciation, and regular depreciation.

YEAR-END MOVE: Place qualified property in service before the end of the year. If your business does not start using the property before 2024, it is not eligible for these tax breaks.

Section 179 deduction: Under Section 179 of the tax code, a business may currently deduct the cost of qualified property placed in service during the year. The maximum annual deduction for 2023 is $1.16 million, provided your total purchases of property do not exceed $2.89 million.

Be aware that the Section 179 deduction cannot exceed the taxable income from all your business activities this year. This rule could limit your deduction for 2023.

First-year bonus depreciation: The first-year bonus depreciation applicable percentage for 2023 is 80% and is scheduled to drop to 60% in 2024.

Qualified Retirement Plans

The new SECURE 2.0 law includes a number of provisions affecting employers with qualified retirement plans.

YEAR-END MOVE: Position your business to maximize available tax benefits and avoid potential problems. Consider the following key changes of particular interest:

• For 401(k) plans adopted after 2024, an employer must provide automatic enrollment to employees. Certain small companies and startups are exempt.

• Beginning in 2023, employers with 50 or fewer employees can qualify for a credit equal to 100% of their contributions to a new retirement plan, up to $1,000 per employee, phased out over five years. The 100% credit is reduced for a business with 51 to 100 employees. This tax break is in addition to an enhanced credit for plan startup costs.

• Beginning in 2024, employers may automatically provide employees with emergency access to accounts of up to 3% of their salary, capped at $2,500.

• Beginning in 2024, an employer may elect to make matching contributions to an employee’s retirement-plan account based on student-loan obligations.

• The new law shortens the eligibility requirement for part-time workers from three years to two years, beginning in 2023, among other modifications.

• Any catch-up contributions to 401(k) plans must be made to Roth-type accounts for employees earning more than $145,000 a year (indexed for inflation).

TIP: This last provision was initially scheduled to take effect in 2024, but a new IRS ruling just delayed it for two years to 2026.

Employee Bonuses

Generally, employee bonuses are deductible in the year that they are paid. For instance, you must dole out bonuses before Jan. 1, 2024 to deduct those bonuses on your company’s 2023 return. However, there’s a special rule for accrual-basis companies. In this case, the bonuses are currently deductible if they are paid within two and a half months of the close of the tax year.

YEAR-END MOVE: If your company qualifies, determine bonus amounts before year-end. As a result, the bonuses can be deducted on the company’s 2023 return as long as they are paid by March 15, 2024. Keep detailed corporate minutes to support the deductions.

This special deduction rule does not apply to bonuses paid to majority shareholders of a C-corporation or certain owners of an S-corporation or a personal-service corporation.

TIP: Note that the bonuses are taxable to employees in the year in which they receive them — 2024. Thus, the employees benefit from tax deferral for a year even if the company claims a current deduction.

Miscellaneous

• Stock the shelves with routine supplies (especially if they are in high demand). If you buy the supplies in 2023, they are deductible this year even if they are not used until 2024.

• Maximize the qualified business interest deduction for pass-through entities and self-employed individuals. Note that special rules apply if you are in a ‘specified service trade or business.’ See your professional tax advisor for more details.

• If you buy a heavy-duty SUV or van for business, you may claim a first-year Section 179 deduction of up to $28,900. The luxury-car limits do not apply to certain heavy-duty vehicles.

FINANCIAL TAX PLANNING

Securities Sales

Traditionally, investors time sales of assets like securities at year-end to maximize tax advantages. For starters, capital gains and losses offset each other. If you show an excess loss for the year, you can then offset up to $3,000 of ordinary income before any remainder is carried over to the next year. Long-term capital gains from sales of securities owned longer than one year are taxed at a maximum rate of 15%, or 20% for high-income investors. Conversely, short-term capital gains are taxed at ordinary income rates reaching as high as 37% in 2023.

YEAR-END MOVE: Review your portfolio. Depending on your situation, you may want to harvest capital losses to offset gains, especially high-taxed short-term gains, or realize capital gains that will be partially or wholly absorbed by losses.

Be aware of even more favorable tax treatment for certain long-term capital gains. Notably, a 0% rate applies to taxpayers below certain income levels, such as young children. Furthermore, some taxpayers who ultimately pay ordinary income tax at higher rates due to their investments may qualify for the 0% tax rate on a portion of their long-term capital gains.

However, watch out for the ‘wash sale rule.’ If you sell securities at a loss and reacquire substantially identical securities within 30 days of the sale, the tax loss is disallowed. A simple way to avoid this adverse result is to wait at least 31 days to reacquire substantially identical securities.

Note that a disallowed loss increases your basis for the securities you acquire and could reduce taxable gain on a future sale.

Net Investment Income Tax

When you review your portfolio, do not forget to account for the 3.8% net investment income tax, which applies to the lesser of net investment income (NII) or the amount by which MAGI for the year exceeds $200,000 for single filers or $250,000 for joint filers. (These thresholds are not indexed for inflation.)

The definition of NII includes interest, dividends, capital gains, and income from passive activities, but not Social Security benefits, tax-exempt interest, and distributions from qualified retirement plans and IRAs.

You may consider investing in municipal bonds (‘munis’). The interest income generated by munis does not count as NII, nor is it included in the MAGI calculation. Similarly, if you turn a passive activity into an active business, the resulting income may be exempt from the NII tax.

TIP: When you add the NII tax to your regular tax, you could be paying an effective 40.8% tax rate at the federal level alone. Factor this into your investment decisions.

Required Minimum Distributions

For starters, you must begin ‘required minimum distributions’ (RMDs) from qualified retirement plans and IRAs after reaching a specified age. After the SECURE Act raised the age threshold from 70½ to 72, SECURE 2.0 bumped it up again to 73 beginning in 2023 (scheduled to increase to 75 in 2033). The amount of the RMD is based on IRS life-expectancy tables and your account balance at the end of last year.

YEAR-END MOVE: Assess your obligations. If you can postpone RMDs still longer, you can continue to benefit from tax-deferred growth. Otherwise, make arrangements to receive RMDs before Jan. 1, 2024 to avoid any penalties.

Conversely, if you are still working and do not own 5% or more of a business with a qualified plan, you can postpone RMDs from that plan until your retirement. This ‘still-working exception’ does not apply to RMDs from IRAs or qualified plans of other employers.

Previously, the penalty for failing to take timely RMDs was equal to 50% of the shortfall. SECURE 2.0 reduces it to 25% beginning in 2023 (10% if corrected in a timely fashion).

TIP: Under the initial SECURE Act, you are generally required to take RMDs from recently inherited accounts over a 10-year period (although previous inheritances are exempted). These rules are complex, so consult with your tax advisor regarding your situation.

Estate and Gift Taxes

During the last decade, the unified estate- and gift-tax exclusion has gradually increased, while the top estate rate has not budged. For example, the exclusion for 2023 is $12.92 million, the highest it has ever been. (It is scheduled to revert to $5 million, plus inflation indexing, after 2025.)

YEAR-END MOVE: Reflect this generous tax-law provision in your overall estate plan. For instance, your plan may involve various techniques, including bypass trusts, that maximize the benefits of the estate- and gift-tax exemption.

In addition, you can give gifts to family members that qualify for the annual gift-tax exclusion. For 2023, there is no gift-tax liability on gifts of up to $17,000 per recipient (up from $16,000 in 2022). You do not even have to file a gift-tax return. Moreover, the limit is doubled to $34,000 for joint gifts by a married couple, but a gift-tax return is required in that case.

TIP: You may ‘double up’ again by giving gifts in both December and January that qualify for the annual gift-tax exclusion for 2023 and 2024, respectively.

Miscellaneous

• Contribute up to $22,500 to a 401(k) in 2023 ($30,000 if you are age 50 or older). If you clear the 2023 Social Security wage base of $160,200 and promptly allocate the payroll tax savings to a 401(k), you can increase your deferral without any further reduction in your take-home pay. Note that SECURE 2.0 further enhances catch-up contributions for older employees after 2023.

• If you rent out your vacation home, keep your personal use within the tax-law boundaries. No loss is allowed if personal use exceeds the greater of 14 days or 10% of the rental period.

• Consider a qualified charitable distribution (QCD). If you are age 70½ or older, you can transfer up to $100,000 of IRA funds directly to charity, free of tax (but not deductible). SECURE 2.0 authorizes a one-time transfer of up to $50,000 to a charitable remainder trust or charitable gift annuity as part of a QCD.

CONCLUSION

This year-end tax-planning article is based on the prevailing federal tax laws, rules, and regulations. Of course, it is subject to change, especially if additional tax legislation is enacted by Congress before the end of the year.

Finally, remember that this article is intended to serve only as a general guideline. Your personal circumstances will likely require careful examination.

Kristina D. Houghton, CPA is a partner at the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C.

Develop a Strategy Now to Be Tax-efficient In Retirement

By Contributor September 29, 2023

Wealth Management

Planning Is the Key

By Barbara Trombley, CPA

Does anyone like to pay taxes? Most of my clients tolerate paying taxes like eating their least-favorite vegetables. They are difficult to calculate and hard to understand, especially with a business generating uneven cash flow or an employed couple with disparate incomes.

But what if I told you there are ways to eliminate taxes in retirement or minimize federal taxes to a palliative 12% bracket?

Tax planning is an important part of retirement planning. When I ask clients what their target monthly spend in retirement is, they never consider the tax effect. For instance, a married couple may say they need to generate $6,000 per month to pay all their bills when they retire. Typically, this means the dollar amount that is deposited in their bank account.

But as a financial planner, I immediately think of the gross amount. How much do we need to generate on a gross level, before taxes, to net them $6,000? Depending on the source of funds, some of my clients may have a tax bill of zero, allowing them to draw only the $6,000 per month out of their investment account(s)!

Barbara Trombley

“When I ask clients what their target monthly spend in retirement is, they never consider the tax effect.”

How can this be? Most retirees rely on Social Security to generate a large portion of their income. Some people pay tax on Social Security, and others do not. Whether you pay taxes or not depends upon your total combined taxable income. Combined income includes your adjusted gross income, any non-taxable interest you receive, and half of your Social Security benefits (adjusted gross income includes earnings, investment income, retirement-plan withdrawals, pension payments, and other taxable income.)

If a married couple has a combined income of less than $32,000, then none of their Social Security income is taxable on a federal level or in Massachusetts. For a single person, the limit is $25,000. Depending on the outcome of this formula, 85% of Social Security benefits could be taxable. The key to paying no federal taxes in retirement is to have other, non-taxable sources of funds.

How can you plan now to possibly pay zero taxes in retirement? A Roth 401(k) or Roth IRA is the best place to start. Most employer 401(k) plans now have a Roth option. This is when your contributions are made on an after-tax basis instead of pre-tax. If you are in a high tax bracket now, you would need to consider the tradeoffs of paying taxes now to not pay later.

In 2023, the limit for Roth 401(k) contributions is $22,500 with a $7,500 catch-up contribution for those over age 50. If you do not have a 401(k) plan at work, you can make a Roth IRA contribution of $6,500 per year, or $7,500 per year if you are over age 50. When you withdraw Roth funds after age 59½, the withdrawals are tax-free and do not impact taxable income.

Another great source of non-taxed income in retirement is investment accounts or savings outside of retirement accounts. If invested efficiently, where capital gains and interest income can be minimized, drawing from these accounts in retirement can have little effect on taxable income. Tax-efficient investing may involve putting interest-generating investments in a Roth IRA and keeping investments that generate long-term capital gains in a brokerage account.

For an example of efficient tax planning, consider client couple A versus client couple B. Both clients are married and file taxes jointly. Each of these couples would like to generate $6,000 per month in cash to spend in retirement. Each client couple generates $3,000 per month in Social Security after paying for Medicare. Client couple A each has a Roth IRA and draws the remaining $3,000 per month out of one of their accounts to meet spending needs. Since withdrawing from Roth accounts is non-taxable after age 59½, they would pay $0 in federal and $0 in Massachusetts state taxes.

Client couple B has only taxable retirement accounts. They draw the needed $3,000 from one of their taxable accounts. If there are no other factors, according to 2022 federal tax tables, they could owe approximately $4,500 in federal taxes and $1,600 in the state of Massachusetts, for a total of more than $6,000 in total income tax!

As a financial planner, I would need to generate an additional $500 per month to cover client couple B’s taxes. If client couple B withdraws a standard 4% from their retirement accounts in retirement, they would need to save another $150,000 during their working years compared to client couple A.

Proper tax planning should be a very important part of retirement planning. Many times, income taxes cannot be avoided, but they can be managed efficiently. Working with your CPA and financial planner is always a good place to start.

Barbara Trombley, CPA is managing partner at Trombley Associates. Securities offered through LPL Financial. Member FINRA/SIPC. Advisory services offered through Trombley Associates, a registered investment advisor and separate entity from LPL Financial. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own, separate from this educational material.

The Region Needs a Growth Strategy

By Editorial January 18, 2023

Opinion

Editorial

As he talked with BusinessWest recently about the prospects for the region in 2023 and beyond, Rick Sullivan, president and CEO of the Western Massachusetts Economic Development Council, stressed the need for creation of a growth strategy for Western Mass.

And he’s right. A region that has become notorious, if that’s the right word, for its lack of growth over the past several decades needs a strategy for bringing more jobs, more businesses, and more vibrancy to the 413.

What goes into such a strategy? Many different things, but it starts with identifying areas where a region can grow and then putting specific strategies in place for making it happen. After all, growth doesn’t occur in a vacuum — it happens where there are opportunities, be it through developable land, location, a large and talented workforce, comparatively lower costs of doing business, an existing infrastructure and critical mass of businesses in specific sectors, a high quality of life, and … did we mention a talented workforce?

These elements have led to profound growth in areas ranging from Silicon Valley to the Research Triangle in North Carolina; from Cambridge to countless towns in Mexico.

The region has several of these attributes, including quality of life, a comparatively lower cost of living (for now, anyway); some available land; a solid workforce trained for some specific sectors, especially manufacturing; a location that provides easy access to Boston, New York, and other major cities; and emerging sectors such as cybersecurity, green energy, and even so-called water technology.

But is this region ready to grow? Can it accommodate more businesses and provide them with the workers they need?

That is a harder question to answer. On the surface, it would seem that, based on the fact that almost every business in every sector, especially healthcare, is struggling to find good help, the answer is ‘no.’ But throughout history, regions have found that, if you create jobs, people will come to that area.

Moving forward, the region needs to take some steps to enable growth to happen. It needs to build its workforce by keeping more young people here and prompting more young people to come here. To do that, there must be jobs, as in good jobs, and places to live. Right now, the region doesn’t have enough of either, which is a problem.

But while creating jobs is important in this new age, the jobs don’t necessarily have to be in the 413. With the advent of remote work, the jobs can be in New York, Boston, or elsewhere, and people can live here.

Either way, this region will need more housing, specifically affordable housing. It will also need a larger and more skilled workforce, which means more training programs and better utilization of one of the region’s best and perhaps least-appreciated assets — its four community colleges.

Meanwhile — and we know you’ve heard this before — it needs to do a better job of telling its story and marketing itself to businesses in other regions of this state and well beyond.

None of this is new, really. The region has known it needs to take these steps and others for years, if not decades now. What would help would be to formalize all this, put a plan together, and take steps to implement it.

Because growth doesn’t happen by accident.

Navigating Uncertain Financial Markets

By Contributor July 7, 2022

Special Coverage Wealth Management

It’s a Time to Stay Focused and Think Strategically

By Barbara Trombley, CPA

If you have a retirement account, as many of us do, it is hard not to follow what is going on in the financial markets today. We are officially in a bear market, defined by a drop of 20% or more in a broad market index.

The Dow Jones Industrial Average crossed into bear market territory on June 13 of this year. Unfortunately, bear markets may plummet even deeper than the 20% threshold and may do so over a prolonged period. It is a tough time to be an investor during this scenario but, eventually, the market finds a bottom and investors feel comfortable once again to begin buying, putting an end to the bear market.

Bear markets are usually the result of a recession or some other financial strain. We are not officially in a recession, but many experts think that one is coming. A recession is defined as a significant decline in economic activity that lasts for months or years. This often means that unemployment rises as companies fail or shrink to control costs. Corporate profits fall causing a decline in stock market prices.

Usually, a bear market signifies tougher economic times ahead. Unfortunately, bear markets are ‘normal’ and happen periodically. We actually experienced a short bear market at the beginning of the pandemic. Bear markets tend to be much shorter than bull markets (when stocks rise over a period of time). They also tend to be less statistically severe, with average losses of 33% compared with bull market average gains of 159%, according to data compiled by Invesco.

“It is a tough time to be an investor during this scenario but, eventually, the market finds a bottom and investors feel comfortable once again to begin buying, putting an end to the bear market.”

What should an investor do during a bear market? Risk tolerance, asset allocation and your age really come in to play right now. The percentage of equities in your portfolio should match your risk tolerance and age. For instance, if you are in your thirties and forties and are investing in your 401(k), you could be very aggressive and have a large percentage of equities.

If this is the case, then you should be thrilled to make your monthly deposit into your account. You are buying stocks ‘on sale’ and you have many years to make up any temporary losses in your account. Even if you are a few years from retirement, and depending upon you situation, a bear market could be seen as an opportunity to purchase stocks at a discount.

A prolonged bear market for someone approaching retirement or a new retiree could mean making some changes to your lifestyle. For example, you could limit withdrawals from your investment account and/or eliminate panic selling. When you withdraw money or sell in a bear market it is considered “locking in the losses.” Perhaps you can cut spending or pick up an extra job for the short term, until the economy is on more stable footing.

There are financial products available that could potentially be suitable in many portfolios. In some cases when determined appropriate, an annuity could be used to create more stable income, a REIT (Real Estate Investment Trust) could be used to help diversity a portfolio and many insurance companies offer products with downside protection. Consult your financial advisor for different ideas to help address the volatility in your portfolio.

Perspective is key to a good night’s sleep when dealing with market volatility. Downturns are a normal occurrence in the stock market. Since 1932, bear markets have occurred, on average, every 56 months (about four years and eight months), according to S&P Dow Jones Indices. Make sure to keep emergency funds in the bank to keep market withdrawals to a minimum. Do not make rash changes to your portfolio. There is a saying that ‘time in the market beats timing the market.’ It is very hard to predict the exact best day to sell a stock or to buy a stock. Missing the best days in the stock market, over time, can seriously undermine your performance. Having a plan and sticking to it could yield the best results in the long term.

If you are a new investor, you may want to proceed cautiously. One potential strategy is to dollar cost average any funds that you have into the market (spread the investment over a period of time). This way you are buying at different price points in the market. Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.

No one is predicting when the market bottom will happen, and it is nearly impossible to time. I believe you should see to have a well-diversified portfolio with a mixture of asset classes, though there is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Always remember the adages “This too shall pass” and “Time is on your side.” Those people that have been investing for a while have been through many economic downturns and have survived and, most likely, thrived if they have stayed the course and stuck to their plan!

Barbara Tromblay is a financial advisor and CPA with Wilbraham-based Tromblay, CPA: (413) 596-6992. Securities offered through LPL Financial. Member FINRA/SIPC. Advisory services offered through Trombley Associates, a registered investment advisor and separate entity from LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

How This Strategy Can Help You Reduce Your Tax Bill

By Contributor March 17, 2021

Banking and Financial Services

Tax-loss Harvesting

By Gabe Jacobson

Tax-loss harvesting is the selling of stocks, ETFs, mutual funds, and other securities at a loss with the goal of reducing taxes on other short- and long-term capital gains.

Does It Apply to Me?

Minimizing taxes is an important goal for investors, and tax-loss harvesting is a useful strategy for reducing your total tax bill. If you sell stocks, exchange-traded funds (ETFs), or mutual funds for a gain this year in a taxable, non-retirement, investment account, you may want to utilize tax loss harvesting to reduce potential taxes on any capital gains generated by those sales.

Tax-loss harvesting applies to investments of all sizes, so whether you have $5,000 or $5 million in your portfolio, you can still benefit from tax-loss harvesting.

Full-service financial advisors usually perform tax-loss harvesting as a part of their service and will coordinate with your tax advisor, but robo-advisors are beginning to offer this service for additional fees. These fees may not make sense given your situation, so consult your tax advisor if you are uncertain. Even in a rising stock market, some individual stocks or sectors may decline in price, giving an opportunity for tax-loss harvesting, which can be done at the end of the year but may be more effective during periods of volatility throughout the year.

You may want to consult your tax advisor about tax-loss harvesting if you have a self-service brokerage account. Pay special attention to tax-loss harvesting if you bought and sold securities within the same year because your capital-gains tax will be much higher than if you held the investments for over one year.

How Does It Work?

Tax-loss harvesting is also known as tax-loss selling because it involves selling securities at a loss, generating capital losses. This seems counter-intuitive. After all, most people buy securities hoping that the price per share will increase over time, allowing them to earn capital gains when they sell. These capital gains, like all other sources of income, come with a tax bill attached.

“Tax-loss harvesting works because capital losses are subtracted from capital gains when you file your tax return, so you pay taxes only on the gains in excess of losses.”

Tax-loss harvesting works because capital losses are subtracted from capital gains when you file your tax return, so you pay taxes only on the gains in excess of losses. However, capital gains and losses are grouped into two buckets based on how long the investments were held for.

Capital gains on securities sold more than one year after the purchase date are considered long-term and are taxed at lower rates. In 2020, the long-term capital gains rates range from 0% to 20%, depending on income levels; most people will fall in the 15% range.

However, if securities are sold within a year of the purchase date, the gains are considered short-term and are taxed at the same rate as wages or business income, which in 2020 range from 10% to 37%. These two buckets cannot be mixed, so you cannot reduce your short-term capital gains by long-term capital losses or vice versa.

Sure, it’s nice to mitigate your tax liability, but wouldn’t you lose more money selling your investments for a loss than you save in taxes? Why not just wait for those prices to bounce back and sell for a gain, assuming you expect the investment’s price to eventually recover? The price may recover down the line, but the tax bill associated with any capital gains generated this year cannot be avoided unless a loss is generated in the same year.

The solution is purchasing a similar asset shortly after selling for a loss. This way, you ‘harvest’ the capital loss for tax purposes while making little actual change to your investment portfolio. The IRS instructs that you must wait at least 30 days before purchasing another asset that is “substantially identical” to the asset sold for a loss, but there are enough similar assets available to allow immediate reinvestment in most situations.

An Example to Clarify

Here is a hypothetical example using common investments: the S&P 500 large-company index and Russell 2000 small-company index tracking ETFs (the prices are fictionalized for ease of understanding, but the ETFs are real and can be purchased through most brokerages).

In this example, in your brokerage account, you purchased 10 shares of iShares Core S&P 500 ETF (IVV) on Jan. 1, 2021 for $100 per share, for a $1,000 total investment. On the same date, you also purchased 10 shares of the iShares Russell 2000 ETF (IWM) for $200 per share, or a $2,000 investment. By Nov. 1, 2021 the price of IVV (the large-company index) has doubled to $200 per share, and you decide to sell five of your 10 shares, generating $1,000 in short-term capital gains.

However, you do not want to pay income taxes on an additional $1,000 on top of your regular wages. You notice that the small company index IWM’s price has dropped to $100 per share, so you lost $1,000 on that investment. You do not want to sell at a loss, but then you realize that, if you sell all 10 shares of IWM, you can generate a short-term capital loss of $1,000 which will completely mitigate the short-term gains from your sale of five shares of IVV when you file your income tax return.

You sell all 10 shares of IMW, but you still want to invest in small-company stocks. You immediately purchase $1,000 worth of shares in iShares MSCI small-cap index fund SMLF with the cash received from the sale of IWM. This fund gives you similar exposure to the Russell 2000 small-company index fund (IWM) you just sold without tracking the same index, meaning the IRS will not consider the two funds “substantially identical,” so you can purchase it before the 30 days are up. At this point, you have effectively received $1,000 in capital gains without generating any taxable gains, and you have maintained your portfolio allocations.

Note that, if you had purchased IVV more than a year before you sold it on Nov. 1, 2021, the gain would be classified as long-term, so the short-term loss generated on the sale of IMW would not offset this gain. Speak to your tax advisor regarding capital-loss carry-forwards, as capital losses not used to offset gains in one year can be applied to future tax years.

Gabe Jacobson is an associate at the Holyoke-based accounting firm Meyers Brothers Kalicka, P.C.; (413) 536-8510.

Despite No Changes in Tax Law, It’s Still a Good Time to Craft a Strategy