Authored by Rahul Setty
When it comes to all matters financial, you can be sure that the government will want a piece of the pie. However, there are a plethora of ways that you, an investor in public markets, can shield your hard-earned capital with several tax-advantaged strategies that we will discuss today.
To be sure, this Brief does not represent personalized financial advice, as the optimal approach for each individual and household will depend heavily on their own unique financial situation, liquidity needs, and investment time horizon. Additionally, note we will be reviewing the US-based investor’s options. For international investors, the same concepts may apply, though with different tax rates and account names which may change one’s suitable approach. Without further ado, let’s begin.
Short Term vs Long Term Capital Gains
Let’s start with some definitions:
- Capital gain or capital loss: The gain or loss on a given asset compared to its purchase price (or cost basis)some text
- Realized (in the context of capital gains): sold
- Unrealized: has not been sold, an existing holding
- Short-term: less than one calendar year
- Long-term: greater than one calendar year
Understanding the difference between short-term and long-term capital gains is crucial to success in the stock market because short-term gains are taxed at the ordinary income rate, while long-term gains are taxed at a significantly favorable rate. Most individuals will fall under a long-term capital gains tax rate of 15%, though in each scenario readers will find it far superior to be a long-term investor.
IRS Capital Gains
IRS: Topic no. 409, Capital gains and losses
Consider two stock market participants, we will call them Trader Terry and Investor Ian, each starting with a portfolio value of $10,000.
Trader Terry and Investor Ian both are top 5% among market participants, and are able to return 20% per year for 10 years. The difference in strategy, as you may have guessed, is Investor Ian did not sell, wanting to give his ideas time to work out and business to run its course. (Yes, never selling anything is an unlikely scenario and builds toughness in the psyche, but this will paint a picture for the purpose of comparison). Trader Terry, on the other hand, sold his ideas within two quarters; as the stock price moved in his favor, he exited his positions.
Let’s assume Trader Terry pays a 22% short-term tax rate, while Investor Ian pays a 15% long-term tax rate.
At the end of this 10-year period, both individuals will have done well, but Investor Ian ends up outperforming his counterpart by a whopping 147% over a 10-year period! Simply by exercising more patience, Investor Ian outperformed. This difference would grow significantly starker over a 30-year window or across an individual’s entire lifetime. Such is the power of lower portfolio turnover over the long run.
Tax Loss Harvesting
Of course, whether one is closer to Trader Terry or Investor Ian, no one is infallible.
Prior to the end of each calendar year, an investor has the opportunity to perform tax loss harvesting within their non-qualified (i.e. brokerage) accounts. This means identifying investments that have declined in value and selling those up to a ($3,000) loss, net. These $3,000 of realized losses (net of any capital gains taken) can be used as a deduction to taxable income for the respective calendar year. Additionally, one can reinvest that money into a different security (one that is not “substantially identical” to the one sold) to repurpose the capital.
Furthermore, after 30 days have passed, the investor is allowed to repurchase the security they sold for a tax loss and still be able to realize the tax loss. This can be helpful if an investor is long-term oriented on a certain security but also wants to realize the loss for tax purposes. Beware though, that many market participants have the same idea, and this can drive trading dynamics late in a given calendar year and early next calendar year. That is to say, timing the market in this manner (as with most) may backfire.
Qualified vs Non-Qualified Investment Accounts
The phrase qualified and non-qualified refer to the presence of favorable tax treatment recognized by the government.
Non-Qualified refers to a brokerage account, whereas Qualified can refer to a Roth or Traditional account, and money must not be withdrawn until age 59.5 with few exceptions.
Roth accounts are those where contributions are made with after-tax dollars. Taxes are paid before money is deposited into the account, and withdrawals are made tax-free, including any earnings from investments. Roth accounts tend to have income limits that may restrict higher earners from contributing, and do not have Required Minimum Distributions. Roth accounts can include a Roth IRA (most commonly) or a Roth 401k through an employer. Notably, Roth contributions can be withdrawn at any time without tax penalties, though the account must be held for at least five years before any capital gains may be withdrawn.
In the case of Traditional accounts, contributions are made with pre-tax dollars, which reduce taxable income in the current calendar year. Withdrawals are taxed as ordinary income, and early withdrawals (prior to age 59.5) are subject to a 10% penalty on top of ordinary income taxes. At age 72, individuals must begin to take Required Minimum Distributions from the account, which are treated as taxable income. This is done so the government can recognize the taxes that were originally deferred at the time of contributing to the account. Types of Traditional accounts most commonly include a Traditional IRA or 401k.
Overall, each account is its own powerful tool, and its optimal usage will depend on one’s current tax rate versus their expected tax rate in retirement. If higher in retirement, the Roth is an ideal account to use, and vice versa for Traditional. The Non-Qualified Brokerage account certainly has its place too, as it provides easy access to capital prior to reaching retirement years. This will be useful to provide maximum flexibility in lifestyle decisions such as purchasing a house or car, providing the seed capital for starting a business, or funding an early retirement.
