Download the 11.25.24 Dynamic Portfolio Perspectives for advisors’ use with clients

By Lucas Felbel, CIMA ® Director, Dynamic Asset Management

Many investors use tax loss harvesting to reduce tax liabilities by realizing losses and using them in the current tax year, or carrying them forward, to offset capital gains in other areas of their portfolio. The benefits of this technique for investors are tried, true and well-known.

See “Portfolio Perspectives: Mastering Tax-Loss Harvesting for Optimal Returns”

However, how many investors have used, or even heard of, tax gain harvesting and its potential benefits?

In 2022, the U.S. workforce comprised 61% W2 employees and 36% independent contractors[1], according to McKinsey’s research. However, in 2023, an Upwork study found that 64 million Americans performed freelance work[2] — an all-time high, representing 38 percent of the U.S. workforce and an increase of 4 million professionals from 2022.

Individuals with variable or seasonal income vary wildly: Realtors, entrepreneurs and small business owners, consultants and self-employed professionals like doctors and lawyers running solo practices — even retirees with regular income. Due to their irregular income from year to year, these types of investors may benefit from tax gain harvesting, and advisors should be aware of the planning opportunities this technique presents.

What is tax gain harvesting?

As opposed to tax loss harvesting, tax gain harvesting is a financial planning technique of intentionally realizing capital gains, usually long-term, in a lower income year at lower capital gains tax rates; this is in anticipation of potential higher tax rates in the future — whether that’s from an increase in income levels, the continued appreciation of a low cost basis security, or from potential tax code regulatory changes.

The goal of tax gain harvesting: To strategically realize gains in a lower-income year or when the taxpayer’s marginal tax rate is lower than it might be in the future. This can reset the cost basis of the investment higher, reducing potential tax burdens if the investment is sold later at a higher income level or higher tax rates.

Use case scenario

A realtor who experiences a slow sales year due to a sluggish housing market might fall into a lower income bracket for that specific year. By realizing long-term capital gains during this period, they can pay significantly reduced or even zero taxes on those gains. This not only improves their financial position by resetting the cost basis higher, but also reduces the risk of paying higher taxes on those gains in a future boom year when income is hitting the 35% and higher income tax brackets.

How to do it?

The identification of opportunities is the most challenging aspect of tax gain harvesting. Technically, it’s easier to execute than tax loss harvesting — no wash gain rules (vs. tax loss harvesting wash sale rules) — because you can sell the position and buy it right back on the same day or within the same hour if you prefer. This maintains the investor’s security exposure, captures a gain at potentially lower tax rates for that year, and resets cost basis mitigating future gains (and taxes) at possibly higher rates. Though tax gain harvesting may be easier to execute, there are caveats with this strategy.  Advisors need to make sure it is a good fit for the client’s unique situation and should be mindful of these two things:

• Realizing capital gains are best done when NOT bumping clients into the next highest tax bracket, raising their tax liability, and
• Any other impacts realizing capital gains could do to other adjusted gross income and modified adjusted gross income-related (AGI/MAGI) thresholds, impacting critical areas of an investor’s financial situation, i.e., government benefit eligibility, state and federal assistance programs, increasing Medicare premiums, income phaseouts for tax credits, etc.

Why is it beneficial?

Using the realtor as an example, here are just a few benefits of tax gain harvesting:

• Capitalize on low-income years: Realtors often have income variability due to market conditions, timing of transactions or seasonal slowdowns. In lower-income years, their marginal tax rate might place them in the 0% or 15% long-term capital gains tax brackets, allowing them to realize gains on investments with little or no tax burden.
• Manage tax bracket increases: Realizing gains in low-income years prevents the risk of being pushed into higher tax brackets and other AGI/MAGI-related tax and other benefit eligibility in the future, which can occur if low-cost basis security gains accumulate and are realized during a high-income year.
• Diversify the portfolio: Realtors may want to rebalance or diversify their portfolio but hesitate to sell due to significant embedded capital gains concerns. Tax gain harvesting allows them to adjust their holdings in a tax-advantaged manner during low-income periods, enabling flexibility of maintaining portfolio risk levels that best align with the client’s overarching financial plan.

Key considerations for advisors with non-W2 clients include the following:

• Monitor client accounts closely for gains and losses, ensuring gains stay within advantageous tax brackets. Tax gain harvesting opportunities are best reviewed near year-end when annual client income is more certain.
• Look for rebalancing opportunities, particularly in a lower income year to realize the gain, increasing diversification and mitigating portfolio strategy drift.
• Assess the impact of realized gains on credits or benefits tied to income thresholds, e.g., healthcare subsidies or education tax credits.
• Use tax planning software to scale and ease the process of analyzing returns. Through Dynamic’s partnership with Holistiplan, advisors can save time reviewing tax returns and access actionable, client-deliverable reports within minutes. Another Dynamic preferred partner, fpPathfinder, can be bundled alongside Holistiplan’s tax planning software to uncover planning opportunities that add value.

Read “Practice Development: fpPathfinder and Holistiplan” for more information on each and why they can be used in tandem by advisors.

• Discuss income expectations for the year. What are analyst projections saying for the cyclical field in which they work? Is the business owner planning to sell at some point? Are they planning to move to a higher or lower tax state? Factors such as individual state tax rates can affect tax gain harvesting strategy.

Above all, ensure harvested gains align with long-term financial planning and investment goals. More than ever, investors with fluctuations in income streams can not only create unique opportunities for tax-efficient investment strategies, but also benefit from personalized financial advice to strategically time and deploy these beneficial techniques. These benefits make tax gain harvesting a potentially valuable solution for smoothing their financial and tax burdens over time — ultimately minimizing clients’ lifetime tax liability.

Invest with intention.

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

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

Disclosures

For advisor use only. 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.

To the extent that this material concerns tax matters, it is not intended to be used by a taxpayer as tax advice. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

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

Photo: Adobe Stock

[1] “Freelance, side hustles, and gigs: Many more Americans have become independent workers,” McKinsey & Company, August 2022 https://www.mckinsey.com/~/media/mckinsey/featured%20insights/future%20of%20america/freelance%20side%20hustles%20and%20gigs%20many%20more%20americans%20have%20become%20independent%20workers/freelance-side-hustles-and-gigs-many-more-americans-have-become-independent-workers-final.pdf

[2] “Upwork Study Finds 64 Million Americans Freelanced in 2023, Adding $1.27 Trillion to U.S. Economy,” Upwork, Dec. 12, 2023 https://investors.upwork.com/news-releases/news-release-details/upwork-study-finds-64-million-americans-freelanced-2023-adding