Supercharge Your Savings Account
Most investors focus only on their retirement accounts such as 401ks, IRAs and pensions and overlook another powerful savings vehicle – the taxable brokerage account. The taxable brokerage account is like a supercharged savings account; just like a savings account, your money is accessible at anytime, but unlike a savings account, you can use a taxable brokerage account to invest in anything such as stocks, bonds, real estate, commodities, etc. The real benefits of taxable brokerage accounts are when investors use the tax laws to their advantage. Below are three of the most commonly used tactics high income earners exercise to minimize and manage their taxes.
Tax Loss Harvesting
Tax loss harvesting is when you intentionally sell an asset (even if you still like the asset) to recognize and bank (harvest) the loss for future use. Of course everyone prefers to see their stock portfolios rise in value, but sometimes investments also lose money. Savvy investors can capitalize on such losses by selling the asset, recognizing the loss, and using that loss to offset other gains. Current IRS rules limit capital loss deductions to only $3,000; the good news is that losses greater than $3,000 can be carried over and used in future years. For example, assume you purchased an investment for $20,000 and sold it for $10,000, you can only deduct $3,000 each year from your taxable income. The remaining $7,000 would carry over to future years to offset future capital gains. So if the following year you sold another investment for a $15,000 capital gain, you would pay tax on only $8,000 ($15,000 – $7,000). When used properly, tax-loss harvesting is a powerful technique used to significantly lower one’s taxable income and hence taxes.
Specific identification is when you identify which investments you want to sell that will give you the biggest tax advantage. Assume you bought 200 shares of the S&P 500 index fund (RSP) in 2 different 100 share lots: you bought the first 100 shares at $50 per share and the second 100 shares at $100 per share. The index is now trading at $75 per share and you want to sell 100 shares. If you have been harvesting your losses throughout the years as mentioned above, you could report to the IRS that you intend to sell the shares you bought at $50 per share to recognize a gain of $25 per share ($75 – $50), but since you’ve been harvesting losses, you would not owe any money on that capital gain. If you already had large gains for the year, you could sell the shares you bought a $100 and recognize a loss of $25 ($75 – $100) to offset the gains. Specific identification requires careful accounting of all of your shares, including reinvested dividends.
Margin loans are when you use your investments as collateral for a loan. Margin loans do not require lengthly loan applications or credit reports because if you default on your loan, your broker will simply sell your collateral and payoff the loan. Margin loans can also be very effective in minimizing taxes. Assume you have a $100,000 portfolio and need $20,000, but all of your investments have sizable gains (and you have not harvested losses) which means you would owe a lot in capital gains if you sold a portion of your investments. By borrowing against the value of your portfolio through a margin loan, you can easily withdraw the money and not owe a penny of capital gains tax. Granted you will have to begin paying the loan back, but the interest on the margin loan would probably be lower than the tax you would have owed had you sold the investments.
The above strategies are just 3 examples of how you can add value to your overall portfolio by opening a taxable brokerage account. You could potentially avoid having to pay capital gains taxes entirely if you strategically combined all three methods. Of course each strategy has its own unique IRS rules so be sure to coordinate with your investment advisor before employing such tactics.
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Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” investment management firm located in Los Angeles, CA specializing in helping doctors and physicians make sound financial decisions. Visit us at www.acapam.com