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Dynamic Portfolio Perspectives: Predictable Tax Planning Improves Investor Outcomes

By Lucas Felbel, CIMA^®, Director, Portfolio Services

Savvy investors and their advisors are always searching for opportunities to reduce unnecessary costs, improve returns and capitalize on opportunities in their financial plans. As traditional investment management becomes commoditized by “robo-advisors” and algorithms that run on autopilot, tax minimizations strategies measured by a metric known as after-tax alpha are gaining attention.

After-tax alpha describes the potential increase in investment returns received through reducing tax costs incurred, and the subsequent opportunities created to use these savings for other benefits within a meticulously crafted financial plan. For investors and their financial advisors, this proactive tax planning stance can help mitigate a potentially unwelcome byproduct of investing: a higher tax bill. As strategies advance around asset management tax planning, investors and their advisors are reaping the benefits. These approaches include tax-loss harvesting, capital gain harvesting, optimizing asset location in certain accounts and charitable giving.

One approach that can help increase after-tax alpha is capital gains budgeting, which is an oft-overlooked option to mitigate investment related tax bills. This technique involves deciding, in advance, the amount of capital gains an investor plans to realize during the year. Such planning facilitates a stronger holistic approach to an investor’s overall investment related tax planning. The goal? To minimize how much an investor pays in investment related taxes in any given year, and to provide a predictable level of capital gains that are acceptable to be realized without derailing an investor’s financial plan.

In this post, we’ll review the basics of capital gains budgeting, offer insight into how a capital gains budget helps with tax-sensitive asset management, and, finally, take a look at the potential beneficial results of a proactive approach towards capital gains management.

Capital Gains Taxes Reviewed

The IRS considers a capital asset as virtually anything an investor owns personally owns and uses, from a home to government bonds to publicly-traded stocks.¹ When capital assets are sold for a profit, capital gains tax will usually apply.² In other words, if an asset is sold for more than its purchase price—minus any expenses to maintain the asset—a realized capital gain occurs.

Capital gains can be divided into two types:³

• Short-term gains: A gain on an asset held for one year or less
• Long-term gains: A gain on an asset held for longer than one year

Short-term capital gains will be taxed using marginal ordinary income levels of the tax-bracket of an investor’s filing status. For example, an investor in the 32% married filing jointly tax bracket would incur a tax bill of $3,200 on a realized $10,000 short-term capital gain. Unique to capital assets, how much you pay on long-term capital gains is determined by your taxable income—though at lower rates, fortunately, than taxes on ordinary income.

Depending on an individual investor’s unique situation, it is often more advantageous to realize long-term capital gains as opposed to short-term capital gains. In the same $10,000 realized capital gain example as above, the long-term capital gains rate would be only 15%, resulting in a $1,500 tax bill–less than half of the short-term capital gains bill. Here’s a handy overview of how long-term capital gains tax brackets work as of the 2024 tax year, which is adjusted for inflation annually by the IRS:

2024 Long-Term Capital Gains Tax Rates

Source: CFP Board⁴

Capital Gains Tax Budgets

Investments operate within the universe of the markets and global economy, which means that the unexpected can occur, potentially upending the best laid plans.⁵ That means that investors and their advisors should review capital gains budgets at least annually to facilitate minimizing tax bills and the knock-on effects of increasing income levels from realized gains as much as possible.⁶ That’s because increasing income levels can result in moving an investor into a higher tax bracket, which can increase an overall tax bill. It is also beneficial to revisit capital gains budgets when there are major life events such as an investor moving to another state with higher or lower state taxes, an investor receiving a promotion at work that upwardly adjusts compensation levels, or a change of marital status.

To engage in capital gains budgeting, investors and their advisors need to first review how much in realized capital gains they have the capacity to incur in a specific tax year. This process involves analyzing all facets of the investor’s specific situation to determine the level of additional investment gains that could be realized each year without triggering adverse effects in other areas of their financial plan. A couple of examples where capital gains budgeting may be especially effective:

• For investors with student debt whose Income Driven Repayment (IDR) plans may be predicated on annual adjusted gross income levels;
• For retired investors enrolled in Medicare whose Income-Related Monthly Adjustment Amounts (IRMAA) premiums may sharply increase if income is $1 over the set threshold, or;
• For high-net worth investors who are at income levels subject to the additional 3.8% Net Investment Income Tax (NIIT)

Targeting a specific capital gains budget can potentially avoid the additional taxes that are associated with a higher tax bracket. In that situation, the investor may pay more in federal taxes than would occur at a lower tax bracket.⁷ There is also the potential for reduction in other deductions and credits with higher tax brackets.⁸

A capital gains budget is a necessary part of any investor’s comprehensive financial plan, no matter how big or small the profits. It’s based on your own individual investment goals, financial strategies and anticipated tax needs.

What’s the result?

Improving investment outcomes is the result of mindful planning, strong communication and adherence to an established processes within the investor/advisor relationship. Investors and advisors who effectively deploy capital gains budgets rightly place contingencies in their plan to avoid adverse tax consequences of the ongoing management of investment portfolios. Adding value through increasing after-tax alpha to investor portfolios with careful consideration can be achieved with many tools, with capital gains budgeting being a strong compliment to an advisor’s tax toolbox.

Invest with Intention.

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Sources:

1. “Topic no. 409, Capital Gains and Losses,” U.S. Internal Revenue Service, Jan. 30, 2024
2. “Topic no. 409, Capital Gains and Losses,” U.S. Internal Revenue Service, Jan. 30, 2024
3. “Topic no. 409, Capital Gains and Losses,” U.S. Internal Revenue Service, Jan. 30, 2024
4. “Provided Tax Tables,” CFP Board, 2024
5. “Capital Gains Budgets for Tax Efficiency,” Jacobson & Schmitt Advisors, Mar. 14, 2024
6. “Capital Gains Budgets for Tax Efficiency,” Jacobson & Schmitt Advisors, Mar. 14, 2024
7. “Here’s What Happens When You Hit a Higher Tax Bracket,” The Motley Fool, May 5, 2023
8. “Here’s What Happens When You Hit a Higher Tax Bracket,” The Motley Fool, May 5, 2023

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For more information, contact Dynamic’s Investment Management team at (877) 257-3840, ext. 4 or investmentmanagement@dynamicadvisorsolutions.com.

As Director, Portfolio Services, Lucas Felbel, CIMA^®, leads the implementation, monitoring and evaluation of trading activities at Dynamic Advisor Solutions.

Disclosures

This commentary is provided for informational and educational purposes only. The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. This is not intended to be used as a general guide to investing, or as a source of any specific recommendation, and it makes no implied or expressed recommendations concerning the manner in which clients’ accounts should or would be handled, as appropriate strategies depend on the client’s specific objectives.

This commentary is not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investors should not assume that investments in any security, asset class, sector, market, or strategy discussed herein will be profitable and no representations are made that clients will be able to achieve a certain level of performance, or avoid loss.

All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed as to its accuracy or reliability. These materials do not purport to contain all the relevant information that investors may wish to consider in making investment decisions and is not intended to be a substitute for exercising independent judgment. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements or assumptions are now or will prove to be accurate or complete in any way.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed.

Investment advisory services are offered through Dynamic Advisor Solutions, LLC, dba Dynamic Wealth Advisors, an SEC registered investment advisor.

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