The goal of financial planning is to build and optimize wealth. Too often, we see people worry about their financial wins, like selling a business or cashing out of a profitable investment, instead of celebrating them. This hesitation is nearly always tied to taxes: How much of my potential profit will I owe to Uncle Sam? Are there strings attached to this windfall? What’s the catch?
A financial advisor (and any other professionals on your team) can help you navigate these potential influxes of cash—we’ll call them big money events. Here are a few of the tools we use at Quorum Private Wealth.
A quick primer on capital gains
To understand the perks of this strategy, it’s important to understand how capital gains taxes work. When an investment increases in value, the income you generate from its sale is known as a capital gain. The government taxes capital gains differently than other types of income; your tax rate depends on your overall income level, the type of investment, and how long you owned it. Long-term capital gains are usually taxed more favorably than short-term capital gains, which are taxed at the same rate as regular income.
In addition to capital gains, however, the government lets you log any capital losses, where you lose money on an investment. These can help offset any capital gains you might report, thus lowering your overall tax bill. You can also carry capital losses forward to the next tax year(s)—you can save them to offset future capital gains.
This tax structure creates several opportunities to minimize the tax burden of big money events if you get strategic and plan ahead.
Before we dive in: Everything we’re about to discuss is intended to be educational in nature and should not be construed as advice; these tools and strategies may not be appropriate for everyone.
A tax-efficient approach to investing
Tax-loss harvesting can help you minimize capital gains taxes. While it sounds simple in theory, it can be challenging to execute. Regulators tend to carefully monitor how it’s used.
With tax-loss harvesting, you sell investments for a loss so that you can harvest those losses, as the name implies, and use them to offset gains. The key here is to sell investments strategically; a loss is still a loss. However, if you’re going to sell investments anyway—perhaps you’re rebalancing or shifting allocations—a financial professional can help you do it in a way that may lower your tax bill.
Many investment products, including certain ETFs, incorporate tax-loss harvesting into their algorithms or operations.
Some sophisticated investors bypass ETFs and instead use a strategy known as direct indexing. This means building an investment portfolio that mirrors an index directly. Removing the middle man, so to speak, can give you more control over how you track a given index—including how you might incorporate tax-loss harvesting. For instance, you might focus more on harvesting losses leading up to a potential big money event.
Long-short extensions
There are some investment managers who look to enhance performance and the opportunity for tax-loss harvesting using a long-short approach.
In a long-short investment strategy, a manager identifies stocks they expect to gain value (the long investments) and those they expect to lose value (the short investments).
Long-short extensions apply that thinking to a classic long portfolio, creating an opportunity for additional tax-loss harvesting.
For example, we might use a 130-30 strategy as a long-short extension with certain clients. Instead of a classic “long” portfolio, where 100% of the holdings are buys that the portfolio managers hope will increase in value—the manager ‘extends’ the size of the portfolio by investing an additional 30% on margin, then selling (or shorting) a corresponding amount (30%) so that the overall exposure is still 100%.
The traditional long portfolio (the original 100%) might include basic tax-loss harvesting. By extending the portfolio, via the long-short extension, you extend the potential for tax-loss harvesting. This approach can help you “bank” capital losses without shifting your overall exposure. Those losses can be used in the future to offset big money events, like an inheritance or the sale of a business.
Additional tax minimization strategies
How you minimize taxes following a “big money” event may come down to the type of capital gain you anticipate. It’s important to select the right tool for the job.
- If you face capital gains tied to a real estate investment, you may be able to use a 1031 Exchange to postpone or mitigate the tax liability. 1031 Exchanges can be complex, so we put together a more detailed explainer.
- These same principles can be applied to help minimize tax on concentrated stock positions, where you might use an exchange fund or a charitable remainder trust.
- If your big money event involves inherited assets, your biggest question will likely surround the step-up basis of those assets. In other words, if you want to sell an inherited asset, is the potential capital gain assessed on the original purchase price or does the asset step up to fair market value? In the latter scenario, you will likely pay less tax. Different states have different rules surrounding step-up calculations; those rules may vary based on your relationship to whomever is leaving you the asset. You may also be able to leverage trusts and certain types of life insurance to help minimize the taxes associated with inherited assets.
- If your big money event is a bonus, including restricted stock units (RSUs) or company stock paid directly to your 401(k), a financial advisor may be able to help you get strategic about how you handle those investments to minimize your tax burden.
- If your big money event is connected to the sale of a business, you may be able to structure the terms of the sale to minimize or dilute your tax obligations. This is a scenario where most people benefit from working with a full team of professionals, including an attorney that specializes in M&A, a tax attorney, a CPA or similar accounting professional, and a wealth advisor, to name a few.
How Quorum can help
At Quorum, we understand that each client’s situation is unique. We’ve covered numerous tax strategies in this article, and this is just the tip of the iceberg. (It’s also meant to be educational in nature and should not be construed as tax or investment advice.) If you think you might be facing a big money event in the future, or if you just want to do a better job of minimizing your taxes during any given year, our team may be able to help.
Set up a time to discuss your specific situation and goals with one of our advisors.
Read more:
The difference between tax planning and tax preparation
Tax location: Why the where matters
Investment accounts: Do you have a tax strategy?
Disclaimer: The subject matter in this communication is educational only and provided with the understanding that neither Sanctuary Wealth or Quorum Private Wealth are rendering legal, accounting, investment advice or tax advice. You should consult with appropriate counsel, financial professionals, or other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.