Take time now for year-end tax-planning strategies

Tracie McMillion, CFA,
Head of Global Asset Allocation Strategy,
Wells Fargo Investment Institute

My calendar tells me there’s still a lot to come in 2022. Autumn. Back to school. Preparation for winter. So why am I writing now about year-end tax-planning strategies? Simply because I believe this is a great time to think about them.

For many of us, as year-end approaches, our lives tend to become increasingly hectic, and it can be easy for things like implementing tax-planning strategies to wind up on the back burner. And that increases the risk they’ll be forgotten completely.

If that occurs, remember there’s little you’ll be able to do after December 31 to help reduce your 2022 tax bill. To help avoid facing that situation, I recommend thinking about these strategies now rather than later.

Use losses to your advantage

So far, 2022 has been bumpy for investors, and you likely have investments that are worth less now than when you purchased them, making this a good year to consider a strategy called tax-loss harvesting.

To show how this strategy may help reduce your tax bill, let’s look at a simplified hypothetical situation: A married couple that files jointly has a net taxable income that exceeds $517,200 this year, so their long-term capital gains are taxed at a 20% rate.

They realized $100,000 in long-term capital gains early this year by selling stock that had appreciated in value while they owned it. Along with their financial advisor, they recently reviewed their portfolio and identified assets they’re willing to sell and, if they did it before year-end, would generate $75,000 in long-term capital losses for 2022.

By realizing these capital losses, they could reduce their long-term capital gains taxes from $20,000 to $5,000, saving them $15,000:

Tax without realizing losses

Long-term capital gains                    $100,000

Long-term capital gains rate                 x  20%

Tax                                                               $20,000

Tax with realizing losses

Long-term capital gains                   $100,000

Long-term capital losses                 ($75,000)

Net                                                              $25,000

Long-term capital gains rate               x  20%

Tax                                                                $5,000

Avoid capital gains taxes completely

If the situation in our example were different and their losses actually exceeded their gains, they wouldn’t owe any long-term capital gains tax and could:

• Deduct up to $3,000 in excess losses from their ordinary income
• Carry over any remaining losses to future tax years

If, for example, their capital losses were $125,000, the couple could use $100,000 to offset the capital gains, deduct $3,000 from 2022 ordinary income, and carry over $22,000 in losses to use in future tax years.

Consider factors besides taxes

While I find tax-loss harvesting to be a useful strategy, there’s a caveat: Don’t let the tax tail wag the dog. By that I mean just because an investment has lost money doesn’t necessarily mean you should sell it simply to realize the loss. Be strategic. Work with your financial advisor to determine the investment’s long-term prospects. If it looks like it may make a turnaround, you might want to hold on to it.

Beware of the wash sale rule

If you like a security’s prospects but still want to realize a loss, you could sell what you own and after 30 days buy the same security to replace it. That way you can both get the tax benefit and continue to hold a position in the security. However, if you take this route, be careful not to violate the IRS’ wash sale rule.

The wash sale rule says you cannot purchase the same, or substantially the same, security either 30 days before or after the date you make the sale (a 61-day period) to realize the loss. If you do, the loss will be disallowed.

For example, you own 100 shares of XYZ stock and its current price is below your cost basis. If you still like the company, you could either:

• Sell your shares today and wait until at least the 31^st calendar day after the trade date before buying XYZ shares to replace them (this leaves 30 days between trade dates)
• Purchase 100 XYZ shares today and then wait until at least the 31st calendar day after the trade date before selling your existing shares to realize the loss (known as the “double up” strategy)

If you want to double up, make sure to consult with your advisor so you don’t double up a mutual fund purchase ahead of its capital gains distribution, which may end up adding to your tax bill. Also, remember November 29 is the last day you can buy additional shares and then sell your existing shares on December 30 (the last day the market is open this year) without violating the wash sale rule.

Make your portfolio more tax efficient

Tax-loss harvesting is just one tax-planning strategy. You may also want to consider separately managed accounts (SMAs) to help improve your portfolio’s tax efficiency. Due to their relatively high investment minimums ($10,000 – $250,000), SMAs may be particularly attractive to higher-net-worth investors.

SMAs let investors directly own the securities in the account and offer access to professional money management and flexibility to customize portfolios to personal needs and objectives. SMAs can comprise individual securities, such as stocks and bonds, but may also include mutual funds, exchange-traded funds (ETFs), and cash.

These accounts tend to be tax-efficient because investors:

• Are taxed only on realized gains in their specific portfolio, unlike mutual funds where capital gains are distributed to all investors
• Have the potential to manage taxation of gains and losses through tax-loss harvesting strategies

If you think SMAs may be appropriate for you or want to learn about other year-end tax-planning strategies, contact your financial advisor.