Helping reduce a client's tax bill is one way some advisers look to add value, and mitigating capital gains tax plays into that broader picture. So how should advisers go about easing that tax burden?
Advisers point out first and foremost that capital gains tax, which is paid on the sale of an appreciated asset, isn't such a bad thing, relatively speaking. Nobody likes paying taxes, but long-term capital gains rates are favorable compared with other tax treatments.
“The avoidance of capital gains tax is a bugaboo that people should get over,” said Tim Kochis, chief executive of Kochis Global, a consultancy to financial planners that focuses on the developing world. “Why are you trying to mitigate it? You should actually be looking for it.”
For example, those in the top tax bracket pay an effective rate of over 43% — a 39.6% rate on ordinary income plus a 3.8% Medicare surcharge. However, the top long-term capital gains rate is around 24% — a 20% capital gains rate plus the 3.8% Medicare surcharge.
This differential typically makes the sale of appreciated stocks, mutual funds and exchange traded funds the most efficient way to generate cash flow, said Mr. Kochis, former chair of the Financial Planning Standards Board. Non-qualified dividends from investments, another way to generate some cash flow, are taxed at 43%, for example, Mr. Kochis said. (Qualified dividends are taxed at the same rate as long-term capital gains.)
Let's say a $100 investment in a stock grows 25%, to $125, after a few years. Paying a 24% capital gains rate on that $25 gain yields an overall tax of 6%, or $6. That's the equivalent of a sales tax on a purchase, Mr. Kochis said.
“If you're going to take a tax hit, that's the kind to take,” said Steve Horan, managing director of credentialing at the CFA Institute.
In terms of minimizing the ultimate capital gains tax, tax-loss harvesting is one of the most straightforward and valuable ways to go about it, advisers said.
The strategy entails offsetting capital gains incurred by the sale of appreciated securities dollar-for-dollar with capital losses from the sale of depreciated securities. Net losses in any given tax year can also be used to offset up to $3,000 of ordinary income, and any beyond that can be carried over indefinitely to offset gains in future tax years.
It's a strategy advisers should take advantage of at least quarterly and not just at year-end, Mr. Horan said, because waiting too long means potentially missing out on a chance to harvest losses. Rules allow investors to sell out of an asset to harvest a loss, and immediately purchase a similar (but not the same) security — a “proxy asset” — to maintain market exposure in a specific area. Investors must wait more than 30 days to re-buy the same security.
“One strategy is to buy a similar security for 31 days so you have proxy exposure, and then switch into the actual security you're interested in after that,” Mr. Horan said.
Mr. Kochis recommends a particular order of operations: First, look for depreciated positions to sell. Then, look to sell securities with gains held long-term (more than one year) before considering those with gains held short-term, because short-term gains are taxed at ordinary income tax rates. Then, look at highest-basis assets first, to minimize the amount of gains per dollar of sale. In the event of greater cash-flow needs, look to lower-basis securities.
Someone who's charitably inclined and has a position in a highly appreciated asset can contribute that asset to charity, receiving the dual benefit of eliminating the capital gain tax and receiving a tax deduction, according to Charlie Douglas, board member of the National Association of Estate Planners and Councils and an Atlanta-based wealth adviser.
However, “if you don't have any charitable intent, it might be better paying capital gains all upfront,” Mr. Douglas said.
Using donor-advised funds and charitable remainder trusts are ways to accomplish the charitable donations, Mr. Douglas said. Investors using a donor-advised fund receive a tax break for the charitable donation that tax year, but can subsequently spread out payments from that asset over a number of years.
With a charitable remainder, an investor is paid an annuitized income stream from the donated asset over a specified time period or lifetime, with the remainder going to the charity afterward. The individual avoids capital gains tax upfront, but must pay income tax on the income received from the trust. The tax deduction is less than one would get from a donor-advised fund, for example, because it's based on the present value of the remainder interest, Mr. Douglas said.
A few caveats with charitable remainder trusts, however, are they can be cumbersome and make the charity wait a while to receive the money, Mr. Kochis said.
STEP-UP IN BASIS
Holding onto a highly appreciated security until death could, in some circumstances, mitigate capital gains taxes, advisers said. Investors get a so-called step-up in basis at death, meaning inheritors of the asset don't have to pay any capital gains tax.
This generally only makes sense for elderly investors whose basis is very low, however, and shouldn't trump a decision to sell based on improving asset allocation and de-risking from concentrated positions, advisers said.
“You can avoid the income tax by not selling, but is the investment risk going to outstrip the tax cost you'd save by not selling it?” said Tim Steffen, director of financial planning in the private wealth management group at Robert W. Baird & Co.
“If something were to go sideways with the market, they could lose a lot more than they'd lose in taxes,” Mr. Steffen added.
ACROSS STATE LINES
Moving to a different state with a lesser tax burden is another legitimate strategy for mitigating capital gains tax, Mr. Kochis said.
“A lot of people do this, particularly as they move into their retirement years,” he said.
Many states levy an additional tax on capital gains income on top of the federal tax. However, taxpayers in a handful of states such as Florida, Texas, Nevada and Washington, which don't assess an individual income tax, don't face an extra state-level capital gains tax.