As fall draws to a close and winter approaches, we reflect on our experiences over the past year. We generally focus on celebrating successes with family and friends. However, it is also an opportune time to revisit portfolios and consider how to harvest losses or gains. This allows us to capitalize on tax incentives and rebalance to maintain preferred asset allocation.

Start your plan this year.

Selling stock should not be a tax-driven decision, but tax consequences are a factor to consider. If you purchased shares of a company over several years and have now decided to lighten your holdings, your choice of which shares to sell could make a big difference on your tax bill.

Understanding your tax basis

Stocks can appreciate or depreciate in value over time. When you sell stock, you create a taxable event. The event will result in a short or long-term loss or gain, based on the change in value and the timeframe the security is held. The taxes on the gains may be offset by realized capital losses.

The tax rates for stock sales are determined by whether they have been held for over a year, and their current value compared to the cost of acquisition. The amount of taxes you pay can be determined by your tax bracket and how it applies to your gains.

Some investment platforms default to a “First In, First Out” basis for executing your sell orders—absent other instructions. This means the lot of stocks being sold will be the oldest lot you own. This is generally a good idea because it prioritizes long-term gains over short-term gains. However, there may be better options depending on your situation. Consider this simplified example:

Mary and John own 40,000 shares of a hypothetical company, which we will call XYZ Corp. They purchased the shares at various times over the past ten years, in four transactions of 10,000 shares each. Below is a summary of their position:

XYZ stock Held for Cost/share Purchase price
Block 1 10 years $5 $50,000
Block 2 5 years $10 $100,000
Block 3 3 years $15 $150,000
Block 4 6 months $10 $100,000

 

Now let us assume Mary and John have decided to sell one block of 10,000 shares and the current price is $12 per share. They face a potential gain or a loss, depending on which block they choose to sell. Additionally, the gain can be long-term or short-term. This table summarizes their potential tax liability if they are in the 35% tax bracket for ordinary income and 20% for capital gains:

XYZ stock Gain (loss) Tax rate Tax due (tax savings)
Block 1 $70,000 20% $14,000
Block 2 $20,000 20% $4,000
Block 3 ($30,000) 20% ($6,000)
Block 4 $20,000 35% $7,000

 

If the couple chooses to sell Block 3, they will realize a long-term capital loss of $30,000, which may be netted against long-term gains for a potential tax savings of $6,000.  If they do not have a capital loss, up to $3,000 of the loss may be deducted from ordinary income.

Harvesting gains based on your tax bracket

In the example above, the worst result might be seen as coming from the default of first in, first out—selling Block 1 and triggering a large tax bill.

What if they both had a difficult year and no other taxable income? In this case, it would actually be best to sell Block 1, because capital gains are taxed at 0% for married couples filing jointly with income under $80,000. They will avoid paying the larger tax in future years.

When to be cautious about harvesting gains and losses

The tax rate on a capital gain from the sale of an asset held for more than a year is generally about half that on the sale of something held for a year or less. This means there is a tax benefit to holding onto gains for a longer period. However, this also means risking a market downturn and reversal on those gains. In today’s volatile financial markets, this call is often not an easy one to make.

Regarding harvesting tax losses, you cannot sell a security to realize the loss, only to rebuy it immediately because you still want to own it. That is known as a wash-sale. IRS rules dictate you cannot buy another security for 30 days that is substantially identical to the one you sold and still recognize the capital loss on the sale.

Tax basis when considering your asset allocation

Another consideration for many investors is to maintain an asset allocation model to mitigate the risk of a downturn—especially as retirement approaches. In good years, stocks will appreciate more than bonds, changing the asset weights of the portfolio. An investor may want to rebalance, but may not want to harvest gains at that time due to their high tax bracket. Instead, they could consider adding additional capital to the underweighted portion of their portfolio to create a better balance without incurring the taxable event.

How we can help

Sometimes steps can be taken to pay more taxes this year and avoid a much higher tax bill next year. It is unknown how exactly the tax structure may change and what effect those changes may have on individual portfolios. It is important to visit with your tax advisors to learn more before taking any permanent steps. Experienced client advisors, such as those at Arvest Wealth Management, can review your portfolio with you, provide recommendations, and help ensure you still match your desired risk profile.

This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.

Arvest Wealth Management does not offer tax or legal advice. Please consult a tax professional.

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