Year-End Investment Tax Planning

July 7, 2016

There’s one certain way to avoid owing tax on capital gains: Don’t sell any investments at a profit. At least, wait until January to take gains, postponing any tax obligation for a year.

Moreover, there’s an argument for staying the course with your stock market holdings. Historically, investors following a “buy and hold” strategy often have outperformed those who tried to move in and out of the stock market. Timing the market has been difficult, if not impossible, and that probably will be the case in the future.

In 2015, the broad U.S. stock market is more than 10% higher than it was at the 2008 peak, before the financial crisis drove down share prices. Investors who held on are ahead of where they were, and have collected seven years of (probably low-taxed) stock dividends in the interim. They’ve avoided paying tax on realized gains as well.

What’s more, investors who truly maintained their strategy reaped another benefit. In late 2008 and in the following years, stocks were “on sale,” as it turned out, selling at what proved to be low prices. Regular investing paid off, without a tax bill from taking gains.

Risk reduction

Staying the course and investing through turmoil sounds like a good way to survive a steep stock market reversal. In practice, though, that plan has flaws. Many people aren’t emotionally equipped to hold onto assets that seem to be losing value, day after day, and to keep investing when stocks trade at lower prices.

Therefore, another tax-efficient way to lower your stock market exposure is to put future investment dollars into cash, bonds, or other asset classes.

Example 1: Art Young has a $500,000 portfolio, with $350,000 (70%) in stocks and $150,000 (30%) in bonds. Art invests $2,000 every month, with that same 70-30 ratio, stocks to bonds.

If Art is truly concerned about a stock market setback, he can stop putting more money into stocks. Starting with the fourth quarter of 2015, Art can put his monthly $2,000 investment entirely into bonds. Over the final three months of 2015 and throughout 2016, Art will invest $30,000 in bonds ($2,000 times 15 months). By year-end 2016, Art’s $530,000 portfolio (without counting interest, dividends, or market moves) will still have $350,000 in stocks. His exposure to stocks will have dropped from 70% to 66%.

The 0% Solution

Instead of buying and holding, Art might sell equities to reduce his stock market exposure. However, profitable sales in his taxable account are likely to lead to a tax bill. Indeed, if Art is working and earning a substantial amount, he might owe 20% on any long-term capital gains, not the basic 15% tax rate. Art also could owe the 3.8% Medicare surtax, depending on the amount of income he reports for 2015. However, the situation could be different for Art’s widowed mother, who has a modest income.

Example 2: Barbara Young estimates that she’ll report $25,000 of taxable income in 2015, after her deductions. This puts her in the 15% tax bracket, which goes up to $37,450 of taxable income this year, for single filers.

For people in the 10% and 15% tax brackets, long-term capital gains are taxed at a 0% rate. As a result, Barbara can sell enough stocks to cause a $12,000 gain in 2015, and stay in the 0% bracket for long-term gains.

The strategy can work well for retired couples because the 15% tax bracket for a joint return goes up to $74,900 in taxable income this year. Married seniors might take enough long-term stock gains by year-end 2015 to fully fill up that tax bracket. The gains will be taxed at a 0% tax rate, and the sellers can reinvest the proceeds elsewhere, if they want to trim stock market risk.

Gain from losses

Although taking gains in his taxable account will create taxes for Art, he can consider taking losses there. Energy stocks and funds have posted losses this year, and the same is true of precious metals securities. With the overall market barely ahead for the year, many individual issues have lost value.

By taking losses this year in his taxable account, Art creates an opportunity to take an equal amount of gains there, untaxed. If he wishes, Art can reinvest the proceeds in other asset classes or put them in the bank, to reduce reliance on stocks.