Why managing your tax bracket matters more than your basketball bracket

Key takeaways

• Thoughtful tax planning may help investors manage how income and investment gains are taxed over time.
• Approaches such as tax-loss harvesting and direct indexing may create opportunities to offset capital gains and manage taxable income.
• Ordinary income and capital gains are taxed differently, which can influence investment and withdrawal decisions.

Every March people around the country start talking about their brackets. Most are referring to their basketball tournament bracket, hoping to predict the winners and maybe earn some office bragging rights. While managing that bracket might get you some office accolades—or a few extra dollars--managing your tax-bracket could have a greater impact on your financial lifetime over time.

Unfortunately, I can’t help you pick the winning team this year. But I can offer a few thoughts on something potentially more valuable: how thoughtful tax planning can potentially help investors better manage their tax brackets.

Over the course of your tax-paying lifetime, two things are likely to change: your tax bracket and the tax code.  While investors can’t control future changes to tax policy,  thoughtful planning may help manage how income and investment gains are taxed over time.

For most taxpayers, the IRS generally separates taxable earnings into two primary buckets for most taxpayers: ordinary income and capital gains.

Ordinary income typically includes wages, interest income from banks or bonds, IRA or 401(k) withdrawals, short-term capital gains as well as less common sources of income.

Capital gains, on the other hand, represent profits from selling investments such as stocks, mutual funds or ETFs. These gains are generally reported on tax forms such the 1099-DIV or 1099-B.

One of the primary goals of investing is to grow and preserve wealth over time. However, maximizing the potential growth of taxable (non-qualified) assets often requires a different approach than investing through qualified assets. Why? Qualified assets and accounts, such as IRAs and 401(k)s, ‘qualify’ for special treatment by the IRS, via tax-deferred growth and tax deductions.  Non-qualified assets and accounts are not so lucky, which means how investment returns are generated—and when gains are realized—can have important tax implications.

These rates are based off your tax bracket. Not your basketball bracket, which is just as complex!

We suffer from the paradox of choice as investors. There are roughly 500 stocks in the S&P 500®Index, about 3000 stocks in the Russell 3000® Index, and thousands of pooled investment vehicles like mutual funds and ETFs. With so many options, building a portfolio can feel like navigating a crowded playing field.

This is where financial advisors can play an important role. By understanding an investor’s goals, circumstance, and preferences, advisors can help construct portfolios designed to align with those objectives.  In some ways, the process is similar to the annual college basketball tournament selection process, when a committee narrows hundreds of teams down to 68 that will compete.

For investors with taxable accounts, one solution that has been gaining traction in recent years is direct indexing.

A Direct Index portfolio is typically implemented through a Separately Managed Account (SMA) where an investor directly owns a basket of stocks designed to track an index like the S&P 500 or Russell 3000. Rather than trying to pick a handful of winning stocks, the approach focuses on broadly participating in the market’s performance.

One reason direct indexing has gained popularity is that owning individual stocks may create opportunities for tax-loss harvesting. Because each stock is held individually, positions that decline in value can potentially be sold to realize a capital loss while maintaining overall market exposure through similar investments.

This process can generate realized capital losses while the overall portfolio may still increase in value over time.

That distinction matters.

Unrealized gains—gains on investments that have not been sold—are generally not taxable. Realized gains, however, typically become taxable when an investment is sold.

Realized losses from tax-loss harvesting may help investors manage their tax exposure in two ways:

• First, capital losses can offset realized capital gains.
• Second, if losses exceed gains, investors may be able to apply up to $3,000 per year against ordinary income, subject to IRS rules.

To illustrate how this concept may work in practice, consider the following hypothetical example for illustrative and informational purposes only and not representative of any specific client outcome.

A married couple is three years away from retirement. They have $500,000 invested in a taxable direct index account, and another $500,000 invested in a taxable stock mutual fund portfolio. Together, they earn a combined salary of $100,000.

In the previous year, their mutual fund paid an 8% capital gain distribution, which appears on their Form 1099-DIV as $40,000 in long term capital gains. Depending on their tax bracket, those gains could be taxed at a 15% federal capital gains rate, resulting in a potential $6,000 federal tax liability.

However, suppose their Direct Index account generated $40,000 in realized capital losses through tax-loss harvesting. If those losses are applied to offset the $40,000 capital gain distribution from the mutual funds, their net capital gain for the year could be reduced to zero, potentially lowering the taxes owed on those gains.

Now imagine the couple decides to retire at age 60 and spend time traveling the country, catching as many basketball tournament games as they can.

Because they may no longer have employment income and have not yet initiated distributions from their qualified accounts (e.g., 401(k) or IRAs), their reportable income may be zero, and they may not have earned income as defined by the IRS.

To help fund their travel, they sell $100,000 from their taxable mutual fund portfolio. If the cost basis of the fund they are selling is $50,000, their net realized long-term capital gain would be $50,000.

Under current tax rules, taxpayers with little or no ordinary income may fall into the 0% long-term capital gains tax bracket, depending on their filing status and total taxable income. If that’s the case, the couple could potentially realize those gains without owing federal capital gains tax for that year.

That could leave more of their portfolio available for travel, experiences and maybe a few arena snacks along the way.

By thoughtfully managing their tax exposure and partnering with an advisor who helps provide future tax planning advice, this couple may be able to delay claiming Social Security benefits for a few years – and postpone withdrawals from qualified retirement accounts, allowing those assets to continue growing tax-deferred.

While filling out a basketball bracket each spring can be fun – and can garner you a few high-fives if done well – managing your tax bracket can potentially be more rewarding.