Part 1 of our Tax Reform article series discussed how to bunch deductions to get the most from your Schedule A Itemized Deductions considering the changes to the standard deduction and Schedule A deduction limitations imposed by the 2017 Tax Cuts and Jobs Act. 

Today’s article focuses on how to take advantage of your lower tax bracket and minimize (maybe eliminate) the capital gains tax associated with your appreciated assets. 

Let’s begin with understanding the structure of our federal taxes.  Our federal income tax is marginal and progressive.  Marginal income tax means there are different tax rates for different income brackets. A progressive tax means the more money you earn, the more you pay in taxes.  Based on current tax rates and tax law, a couple who files as “married filing jointly” who earns $ 77,000 will pay less in tax than a couple who earns $200,000.  This is not just in real dollars but an actual lower percent.    All things being equal, the effective tax rate of our $77,000 couple is 11.3% while the effective tax rate of our $200,000 couple is 17.5%.

In addition to income tax, Uncle Sam imposes sales tax, property tax, estate tax, and capital gains tax to name a few common ones.  

Your income is taxed based on the source of your income.   Wages, salaries, interest received, and non-qualified dividends are taxed as ordinary income.  Ordinary income is taxed based on your marginal tax rate.  (See Appendix A).  Capital gains are taxed based on the type of gain it is.  Short-term capital gains (gains that you realize if you sell an investment within a year of owning it) are taxed as ordinary income.  Long-term capital gains (gains that you realize if you sell an investment after owning it for a year or more) are taxed at 0%, 15%, or 20% depending on your marginal income tax bracket.  These are known as long-term capital gains tax rates.  (See Appendix B).

Why all this attention on taxes?   Because the better you understand the relationship of your income to your taxes, the better decisions you can make about your investment portfolio and its impact on your bottom line.

In past years, investors may have held assets longer than necessary to avoid the higher taxes associated with short-term capital gains.  With the recent tax law changes, there is a good chance you are now in a lower income tax bracket than you have been in past years.  It may make sense to sell an asset and capture the gain within the first 12 months of ownership since the taxes would be less than in former years.   After all, a gain in the first 12 months may become a loss after 12 months.   In former years, if a couple earned $160,000, and they realized a short-term capital gain, they would pay 13% more in tax than if they had postponed the sale.   In our current tax environment, this same couple would only pay 7% more in tax by realizing a short-term capital gain.   Paying less to Uncle Sam means more money in your pocket.

Taxes are an important consideration when making portfolio decisions.  Understanding how they affect a portfolio can help investors make more educated choices.   Portfolio adjustments should always be made with the end in mind.  The ultimate goal of portfolio management is to help you reach your financial goals.  Are the portfolio decisions you make today keeping you on track to reach your long-term financial goals?  Capturing a gain at a slightly higher tax bracket by paying ordinary income taxes instead of long-term capital gains rates may be just what your portfolio needs, and the new tax law helps you do that.

Appendix A

2019 Tax Table – Married Filing Jointly

Appendix B

2019 Capital Gains Tax Rates – Married Filing Jointly

Securities and Advisory Services offered through The Strategic Financial Alliance, Inc. (SFA) – Member FINRA, SIPC.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary.  The SFA does not provide tax or legal advice.