Income Taxes – Tax Savings For Eligible Individuals

Tax Savings

Regular readers of our blog may recall a posting from October 6, 2020 that looked at the history and evolution of our federal Income tax system. Our next four articles will discuss some ideas and strategies that can result in tax savings for eligible individuals. It is a well-established fact that many Americans have a limited understanding of our tax code. However, that ignorance can cause them to miss out on some savings opportunities and/or pay more income taxes than necessary. Keep in mind that we will not be suggesting aggressive accounting for deductions and dubious tax shelters. Rather, we’ll call attention to some 100% legitimate ideas for reducing an income tax bill. You simply must be aware of the strategy in order to employ it!

Many taxpayers do not understand that the tax code does not treat all forms of income equally. Wages, interest, non-qualified dividends1, and short-term capital gains are all treated the same. They are taxed as ordinary income which means that each additional dollar of this type of income is taxed at the highest marginal rate for the taxpayer. This rate is determined by the appropriate tax bracket and could be 10%, 12%, 22%, 24%, 32%, 35% or 37%, depending on overall income levels and deductions. Conversely, some forms of income receive preferential treatment.  For example, long term capital gains and qualified dividends are taxed at a rate of 0%, 15% or 20%, depending on total income. Since these tax rates are lower than the rates on ordinary income, they create the opportunity for some judicious tax planning.

Loss harvesting and gain harvesting are two examples. Loss harvesting is a strategy that has been practiced for many years and may allow a taxpayer to share a portion of an investment loss with Uncle Sam. On the tax return, realized long term2 investment gains are netted against realized long term losses. Similarly, realized short term gains are netted against realized short term losses. These two net figures are then netted against themselves. If this final figure is a loss, up to $3,000 can be used to offset ordinary income reported elsewhere on the tax return. In addition, net losses exceeding the $3,000 annual limit can be used in future tax years in much the same way. Good tax planning entails harvesting losses on investments that have decreased in value, because even though nobody plans to lose money on an investment, it inevitably happens from time to time. It can even make sense to sell an “underwater” investment that one would still like to own for the long run. The investment can be repurchased after the loss has been harvested, as long as the IRS “wash sale” rules outlined in IRS Publication 550 are followed.

Gain harvesting is less commonly practiced, but it can result in significant tax savings over time. This strategy takes advantage of the fact that long term capital gains tax rates for some taxpayers can be zero. For 2020, this group includes joint filers with taxable incomes below $80,000 and single filers below $40,000. Any unrealized long-term capital gains can be considered, even if the investor would like to continue to own the investment in question. There are no “wash sale” restrictions on capital gains so the investor harvests the gain by selling and then subsequently repurchasing the same investment. Tax savings come into play in two ways. First, qualifying tax payers reap the long term capital gain from the sale at a 0% tax rate, as long as this additional income doesn’t push their total income above the thresholds mentioned previously. Second, by repurchasing the investment shortly after selling, the cost basis of the investment will have been “stepped-up” to a new higher level. This “step-up” will result in a lower capital gain and lower taxes if the same investment is sold once again in the future. Conversely, the newly repurchased security may decline in value in the future and with a new, higher basis, can result in greater tax savings on the harvested capital loss.     

If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.  You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

1Qualified dividends are defined by a lengthy (as usual) IRS definition.  Briefly, they must essentially be issued by a US corporation or a foreign corporation with specific ties to the U.S. In addition, the payee had to have owned the security during the 121 day period that begins 60 days before the ex-dividend date.   Non-qualified dividends do not meet the definition.

2Long term refers to an investment that has been owned for more than 365 days.  Short term refers to any holding period less than one year.

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