US Year End Planning: Estimating Capital Gain Distributions and Assessing the Benefits of Tax Loss Harvesting

Over the last few weeks mutual fund companies have begun publishing their estimates of year end distributions that will be made, mostly in December.  As you review income realised to-date throughout the year (either through realised capital gains, dividends or interest), it can be beneficial for a number of reasons to factor in the anticipated distributions for the remainder of the year.

First, if distributions are projected to be quite high and depending on individual circumstances it may make sense to hold off on investing new cash going into a particular fund or to time rebalancing of a portfolio to minimise exposure to the distributions.

Secondly, those who have a good idea of what their annual income will be from all sources, they should be able to assess their overall tax position for the year. One thing to look at is the extent of exposure to the extra 3.8% Net Investment Income Tax (NIIT) or the top marginal tax bracket of 39.6% which would result in an individual’s qualified dividends and long-term capital gains being taxed at 20% versus 15%. If income hovers around the relevant thresholds it can be very valuable to think about whether there is anything that can be done to reduce net investment income or overall taxable income.

It is very possible to be in a position where some positions within an investment portfolio have an unrealised loss since purchase. This is important to keep in mind when you are looking at impact in both jurisdictions. If there are realised gains already during the tax year, it may be possible to reposition the portfolio to realise some losses and offset some, if not all, of those gains. Even if there aren’t gains, selling assets that have fallen in value could generate losses that can be carried forward and used to offset gains in future years or reduce ordinary income in the current year by up to $3,000.  Any offset of ordinary income will be equivalent tax savings at the same rate as short-term gains, interest income and non-qualified dividends. Given the fluctuation in exchange rate this year, when assessing impact, consider unrealised gains in both USD and GBP terms as many USD unrealised loss positions may actually equate to gain positions in GBP terms. Of course, individuals in the UK will be able to utilise their capital gains allowance in the first instance to offset GBP realised gains.

An example can illustrate the potential benefit from tax loss harvesting (which depends heavily on the individual’s income level and the amount of both short-term and long-term gains).  For those in the highest income tax bracket of 39.6% and subject to the 3.8% NIIT, short-term gains are taxed at a rate of 43.4%. However, long-term gains will attract an overall maximum rate of 23.8%. An individual will first want to limit short-term gains to the extent possible as this would result in the most tax savings. For instance, if an individual has $20,000 in short-term gains, this can result in a tax savings of up to almost $8,800 if offset by relevant capital losses. Short-term and long-term losses must be used first to offset gains of the same type. But if losses of one type exceed gains of the same type, then one can apply the excess to the other type. So, if one has realised short-term gains, then short-term losses should be realised or realise enough long-term losses to cover any realised long-term gains and short-term gains. The least effective strategy would be to apply short-term losses to long-term gains as this strategy would mean giving up the potential 43.4% tax offset to reduce taxes by 23.8%.

Being strategic about how to realise gains and losses has the potential to save an individual a large amount of tax depending on individual circumstances. But, one should be sure to keep good records and continue to take portfolio diversification and any required rebalancing into account when assessing tax loss harvesting opportunities.

For more wealth planning tips and tidbits from MASECO read our 39 Steps to Smart Living in the UK.

Risk Warnings and Important Information
The above article does not take into account the specific goals or requirements of individual users. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.

MASECO LLP trading as MASECO Private Wealth is authorised and regulated by the Financial Conduct Authority, the Financial Conduct Authority does not regulate tax advice.  MASECO Private Wealth is not a tax specialist. We strongly recommend that every client seeks their own tax advice prior to acting on any of the strategies described in this document.

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