One of those financial rules of thumb that can hurt you – It’s always better to pay later rather than paying now.
The question isn’t just whether you should pay now or pay later. The question is also whether you should pay more or pay less. Depending on your circumstances, you could pay less in taxes for the same amount of capital gain if you take the gain sooner rather than later.
Timing sales of investments as a planning tool
You often hear of tax loss harvesting at the end of the year. This is a process where you examine your investment portfolio and look for investments that would have capital losses if you sold them today. Investors may do this if they are hoping to manage their tax bill because they can use some of those capital losses to offset capital gains that they have had during the year.*
You hear less about looking to take capital gains and yet, it can be a useful planning tool.
How our tax system works
Imagine that, hypothetically, as you earn income, you pay the government a percentage of your income so that you can keep the rest. (It isn’t hard to imagine, is it?) As you earn your income, you use it to fill up red buckets. Let’s say the first red bucket will hold $19,050. In order to take home the first bucket that you fill up, you have to pay the government 10% of what is in the bucket. The second bucket will hold about $58,350. In order to take home the money that’s in that bucket you have to pay the government 12% of what’s in the bucket. Next is the third bucket that will hold about $87,600. You’ll have to pay the government 22% of what’s in that bucket to take it home. Let’s say this goes on for 7 red buckets and that last bucket holds any income you earn over $600,000. You’ll pay the government 37% of what’s in that bucket to take it home. This is pretty much how federal income taxes on your taxable income work.
Now let’s say you happen to have a nice portfolio of investments that you have held for more than a year. If all went well, the investments in your portfolio have increased over time. If you sell some of those investments that have increased over time, they will generate capital gain income. Just like above with your earned income, you will also be paying the government a percentage of this income. However, after the Tax Cuts and Jobs Act of 2017, we can’t use the same buckets as the scenario above. There are two different sets of brackets or buckets – one for ordinary income and one for long-term capital gain income. Using the same money from above (yes, take all the money back out of those buckets), you fill up a different set of buckets – the blue buckets. The first blue bucket holds $77,200. Let’s say that if you only fill that bucket and don’t go into the second bucket that you don’t have pay the government a portion of your long-term capital gains (you still have to pay the tax for the ordinary income – the part we did with the red buckets). If your income goes into the second bucket which can hold up to $401,800, then you have to pay 15% of your long-term capital gains to keep the rest of your long-term capital gains. And if your income spills into the third and final blue bucket, you have to pay the government 20% of your long-term capital gains in order to keep the rest. Short-term capital gains are taxed as ordinary income.
How this affects you
Let’s say that things have gone well for you and in that investment portfolio you have a few stocks or other investments that have done very well over the past few years (also not too hard to imagine). Now, since they’ve grown so much, they represent a larger portion of your portfolio than you would like (because you prefer to have a well-balanced, diversified portfolio). However, you are aware that if you sell one of those investments with the large gains, you will have to pay tax on those gains.
How does timing help?
Now consider this possibility. Perhaps you’ve had a dip in income this year – smaller bonus, fewer hours, etc. Or you simply expect a significantly larger income next year. Does it make sense to wait to sell that stock with the gains? The tax rates on capital gains are tied to your taxable income. In our example with the blue buckets above, if you have the opportunity to take a gain from selling an appreciated investment in a year when you only fill two buckets rather than three, you can pay the government 15% of your capital gains in order to keep the rest. If you wait until next year when you think you might fill two buckets and spill into the third, you would pay the government 20% of your capital gains. In a year when you reach fewer buckets, you pay the government a lower “price” to keep the rest of your money. If you already know that you will fill more buckets next year, you already know that you will have to pay the government a larger share of your income.
So, if you anticipate a higher income in the coming years, it may be worth considering taking a capital gain this year. Yes, you will pay more in taxes this year than you would without the additional income this year. But it may be worth choosing to take the income when you can control which buckets you fill. By taking the income when you can stay in the lower buckets you get to keep a larger percentage of your income and pay a smaller percentage to the government. Sometimes it does make sense to pay taxes earlier – especially if the tax is at a lower rate.
*Keep in mind, everyone’s situation is different and this is a very simplified view of our progressive tax system. You should consult with your tax advisor to determine the right course of action for you.