Traditional tax planning for portfolios has been relatively straightforward - given that the same maximum capital gains tax rate applied regardless of whether someone had $100,000 or $1,000,000 of income, the dominant strategy was simply to defer capital gains as long as possible, and harvest capital losses to further maximize the benefit.
In today's world, however, the introduction of both a new top 20% long-term capital gains tax rate, and a 3.8% Medicare surtax on portfolio income, makes the picture far more complicated. Instead of just having two long-term capital gains tax brackets that reach a cap at $72,500 of income (for married couples), there are now four capital gains tax brackets, that extend as high as $450,000 before the top rate is reached!
The end result of this graduated four-tax-rate structure is that now it's no longer best to just defer capital gains indefinitely, which - just like accumulating a huge IRA - could eventually drive the client's tax rates higher as income is ultimately recognized in the future! Instead, tax planning for portfolios becomes more proactive, where some years it's still best to harvest capital losses, but in other years it's better to harvest the gains, instead!
The New Third Capital Gains Tax Bracket
Under the American Taxpayer Relief Act of 2012 (ATRA), Congress not only made permanent the existed 0% and 15% long-term capital gains rates, but also introduced a new 20% long-term capital gains tax bracket that will apply beginning in 2013 for high-income taxpayers. The new bracket applies at a taxable income threshold of $400,000 for individuals, or $450,000 for married couples, which corresponds to the starting point for the new 39.6% ordinary income tax bracket. As a result, financial planning clients now face three prospective long-term capital gains tax brackets: 0%, 15%, or 20%, which is determined by looking at what ordinary income tax bracket the gains would have fallen within. The chart below summarizes the thresholds.
|Individual Thresholds||Ordinary Tax Bracket(s)||L/T Capital Gains Bracket||Married Couples Threshold|
|Up to $36,250||10% & 15%||0%||Up to $72,500|
|$36,251 - $400,000||25%, 28%, 33%, & 35%||15%||$72,501 - $450,000|
|Over $400,000||39.6%||20%||Over $450,000|
An example may help to illustrate. Assume a married couple has $100,000 of ordinary income after deductions, and takes a large $500,000 long-term capital gain. The first $350,000 of the capital gain will fall within the 25%, 28%, 33%, and 35% ordinary income tax brackets (up to $450,000 of taxable income total), and consequently will be subject to the 15% long-term capital gains tax rate. The remaining $150,000 will fall within the top ordinary income tax bracket, and therefore will be taxed at a 20% rate. Thus, as with ordinary income tax brackets, the rates are graduated and only apply at the margin - new dollars that fall within the new bracket are taxed at the new higher rate, while the prior dollars remain in the lower brackets. With a combination of both ordinary income and long-term capital gains, the tax code prescribes that ordinary income is always first (favorably filling the bottom tax brackets), and the long-term capital gains stack on top, at whatever (ordinary income and associated long-term capital gains) brackets they fall within. To the extent the taxpayer has deductions, they are applied (again favorably) against the ordinary income first.
Notably, if the preceding client simply had a $500,000 long-term capital gain and no ordinary income (because it was fully offset by deductions), then the capital gains would have spanned across all three brackets; the first $72,500 of capital gains (up to the top of the 15% ordinary income tax bracket) would have been taxed at 0%, the next $377,500 would have been taxed at 15% (filling the 25%, 28%, 33%, and 35% ordinary income brackets), and the last $50,000 of long-term capital gains would have been taxed at 20%. The total long-term capital gains tax would be $66,625, which is equivalent to a blended rate of 13.325%.
Adding In A Fourth Capital Gains Tax Bracket
The caveat to the preceding example and chart is that in addition to ATRA creating a new 20% long-term capital gains tax bracket in 2013, another law kicked in for 2013 that also impacts capital gains: the new 3.8% Medicare surtax on "unearned" income, as a part of the Patient Protection and Affordable Care Act, applies to a wide swath of investment income, including interest, dividends, rents, royalties, annuities, passive income, and any taxable capital gains. The new surtax applies at thresholds of $200,000 of Adjusted Gross Income (AGI) for individuals, and $250,000 of AGI for married couples. While capital gains that are excluded from income are also excluded from the new Medicare tax, any capital gains that are taxable - and subject to the three capital gains tax brackets shown above - will face the 3.8% Medicare surtax as well.
Notably, the new Medicare tax is calculated based on AGI - which is income before personal exemptions and itemized deductions - while the ordinary income tax brackets (and therefore the long-term capital gains tax brackets) are based on taxable income after subtracting personal exemptions and itemized deductions. As a result, the $200,000 / $250,000 Medicare tax AGI thresholds will not always match up perfectly with the taxable income brackets noted above.
Nonetheless, barring an unusually large amount of itemized deductions, virtually no one who faces the 3.8% Medicare surtax on capital gains will be eligible for the 0% long-term capital gains tax rate (as it's hard to get from $200,000 of AGI down below $36,250 of taxable income from below-the-line deductions alone!); instead, the new surtax will apply generally to those who face the 15% and 20% long-term capital gains rates. On the other hand, because the surtax kicks in at $200,000 / $250,000 of AGI before deductions, and the new 20% capital gains rate applies at $400,000 / $450,000 of taxable income after deductions, then anyone who faces the 20% rate must be subject to the surtax, for an actual rate of 23.8% (if the person's income was over $400,000 / $450,000 after deductions, it must have been even higher before deductions, so it certainly would have been above the Medicare surtax AGI thresholds). For those in the wide middle brackets - and subject to the 15% long-term capital gains tax rate - the Medicare surtax might apply (bringing the rate up to 18.8%) but might not (leaving the rate at 15%).
The net result: there aren't just three capital gains tax brackets now, but four (brackets based on taxable income, unless otherwise noted)!
|Individual Threshold||Married Threshold||L/T Capital Gains Rate|
|Up to $36,250||Up to $72,500||0%|
|Over prior, up to $200,000 of AGI||Over prior, up to $250,000 of AGI||15%|
|Over prior, up to $400,000||Over prior, up to $450,000||18.8%|
|Over $400,000||Over $450,000||23.8%|
For clients subject to the Alternative Minimum Tax, these capital gains rates and thresholds also apply - they are simply calculated using the regular tax system, before the tax rates that apply to other ordinary income is converted to the AMT system. However, it's important to note that those who are subject to the AMT and phasing out the AMT exemption can end out facing a 6% - 8% "surtax" as greater capital gains reduce the amount of the exemption; this rate would apply in addition to the amounts shown in the table above!
Planning Around The Four Capital Gains Tax Brackets
The presence of four long-term capital gains tax brackets presents significant complications for traditional portfolio tax planning. In the past, planning was relatively simple - if someone had income low enough to be eligible for 0% rates, it was nice to get gains for "free" and everyone else just deferred gains as long as possible. After all, if you're going to pay 15% now or 15% in the future, there's little sense in paying sooner when you could pay later!
With four graduated long-term capital gains rates, though, the landscape begins to look different. It's not just 0% for lower-income individuals, and 15% for everyone else. In point of fact, the shift began last year, when the looming onset of the new 3.8% Medicare tax itself - not to mention the potential fiscal cliff lapse back to higher capital gains tax rates for all - made it appealing to consider harvesting capital gains at then-current rates, stepping up cost basis to reduce exposure to the new tax rates that would begin in 2013.
The planning opportunity now continues in 2013 and beyond. With four capital gains tax brackets, the reality that while the popular tax loss harvesting may be popular in years where income is high, the optimal strategy in lower-income years is to harvest the gains instead. And it's not just harvesting capital gains for those who are eligible at 0% rates; harvesting at 15% or 18.8% may still be more appealing than paying capital gains taxes at 18.8% or 23.8% in the future! In other words, gains harvesting is now on the table for anyone who's not already in the top capital gains tax bracket - in reality, this was always true, but the top capital gains tax bracket where rates remain flat has moved from $72,500 (the top of the 15% ordinary income bracket) to $450,000 (the bottom of the 39.6% ordinary income bracket). For everyone in the middle, harvesting capital gains is now a new ongoing tax planning strategy, which primarily impacts the "middle class" and mass affluent whose incomes fall within this range.
Of course, if an investment was going to be held for years or decades, tax deferral still has value, and there's still no beating holding an investment until death when it gets a tax-free step-up in basis anyway. But for investments that may have possibly been sold in the coming years anyway - whether to fund college expenses, retirement spending, or simply because of an anticipated investment change - the reality is that the economic value of tax deferral is far smaller than the potential impact of higher tax rates in the future. As a result, investors who anticipate that income in the next year or two is higher than today might wish to sell an investment, immediately buy it back (there's no such thing as a wash sale for capital gains!), recognize the gain, step up the cost basis to the current market value, and reduce exposure to capital gains in the future when the tax rate was anticipated to be higher! In addition, the value of harvesting capital gains makes it important to not harvest excessively losses and create capital loss carryforwards anymore - because loss carryforwards must be used to offset against gains, even if it turns out the gain was 0% and the lower cost basis (from the loss carryforward harvesting) triggers a larger capital gain at higher rates in the future!
Notably, the benefits of harvesting gains amongst the four capital gains tax brackets will shift over time, due to the fact that the ordinary income tax bracket thresholds are indexed for inflation, but the 3.8% Medicare surtax threshold is not. Over time - all else being equal - the 0% capital gains tax bracket will grow, but the 15% capital gains bracket will shrink (as the current $72,500 threshold moves closer to the $250,000 AGI threshold for the Medicare surtax); at the same time, the 18.8% bracket will grow, as the $450,000 threshold to move from 18.8% to 23.8% increases with future inflation adjustments.
Nonetheless, the bottom line is that in today's environment, with four capital gains tax brackets that continue to increase all the way up to $400,000 / $450,000 thresholds, anyone below the line is potentially exposed to a rising series of tax brackets on capital gains. Strategies that are too effective in deferring capital gains can actually result in wealth destruction, by stacking income so high that it's exposed to the higher capital gains tax brackets! In turn, this means it's more crucial than ever to proactively evaluate from year to year whether to harvest capital losses (when income is high), or harvest capital gains! In addition, be certain that you've set an appropriate default method of accounting to ensure that partial sales of investments also take advantage of the appropriate loss- or gains-harvesting strategy from year to year!
Mitchell Fox says
Great insight on this rule that I hadn’t considered.
Just to make sure I’m following your proposal, you would essentially suggest that tax advisors should be guiding their clients to harvest capital gains up to the point that they “fill up” their current gains rate?
A married client with $200K of earned income, and no realized gains but lots of unrealized gains, should (situation dependent) be selling up to $50K of those assets in order to “top up” to the $250K limit for the 15% rate?
Michael Kitces says
All else being equal, yes that’s the goal here. With the caveat that if the couple is truly safely going to stay in this bracket, they can let the gains go for another year or two (but still be cautious not to let TOO much accumulate that you drive up the future rate). And obviously, if the client’s rate is actually expected to drop because this is an unusually high year, by all means wait on the gains and let them drop.
But the fundamental point is that with the ongoing risk that deferring more and more gains will eventually lead to higher tax brackets (for those not already in the top tax bracket), just pushing the gains out indefinitely can result in less final wealth than harvesting incrementally along the way.
Damon Deru says
Great article Michael! It’s the best one I’ve seen on the topic so far, and a concept a lot of advisors aren’t thinking about because the traditional thinking has always been to defer taxes as long as possible. Now the trick will be selling the idea to clients! I can hear them now, “We’re harvesting taxes, why?”
I might add a plug for tax-efficient rebalancing software here as a way for advisors to realistically analyze and manage this process.
Annette Di Bello CPA CFP says
Fantastic article, thank you so much. Annette