5 benefits of a capital gains retirement strategy
by Robert Klein CPA, PFS, CFP, RICP, CLTC, MBA, MST
One of the incentives for saving for retirement for self-employed individuals is the tax deduction for retirement plan contributions. A popular choice is the simplified employee pension, or SEP, plan. Deductible contributions of up to 25% of net self-employment income, with a limit of $52,000 for 2014 and $53,000 for 2015, may be made to this type of plan.
Suppose you're self-employed and you have a sizable capital-loss carryover, should you contribute to your retirement plan or should you do something different this year? One possibility is using a portion, or perhaps all, of the funds to invest in nonretirement plan growth investments. This may include, but isn't limited to, a diversified investment portfolio and/or real estate.
Why would you do this? Here are five reasons:
1. Generate capital gains to free up capital losses
While the tax law allows a generous inflation-adjusted deduction for contributions to retirement plans for self-employed individuals, the historical tax treatment of capital losses is quite different. The amount of capital losses in excess of capital gains that can offset other types of income in any year has been limited to $3,000 since 1978. Any surplus losses must be carried forward to future years.
Given this limitation, you need to generate capital gains to use any meaningful portion of a capital-loss carryover. If you're like many self-employed individuals who use all of their available funds for retirement plan contributions, you may have minimal nonretirement investments. By investing in these types of assets, you create the opportunity for future capital gains.
2. Use 100% of capital losses during your lifetime
Although you can carry forward unused capital losses to future years' tax returns as long as you live, it's possible that you may not use all of your capital-loss carryover during your lifetime. This is likely if you have a large carryover and either you don't create sufficient capital gains or you incur additional capital losses in future years.
To the extent that you sell appreciated assets, you may be able to realize capital gains to offset 100% of capital-loss carryovers during your lifetime.
3. Eliminate taxation of capital gains
If you realize a gain on nonretirement assets that you sell after holding them for more than a year, you're entitled to favorable long-term capital gains treatment. To the extent that you have a capital-loss carryover that can offset your capital gains, you can eliminate taxation of those gains.
4. Reduce taxation of retirement plan assets
100% of retirement plan contributions, as well as appreciation and earnings, will be taxed as ordinary income at unfavorable tax rates beginning no later than April 1 of the year following the year that you turn 70-1/2. You can reduce your future tax liability by redirecting a portion of funds that would otherwise be used to make retirement plan contributions to nonretirement plan assets.
5. No limit on investment amount
Unlike retirement plan contributions, there's no limit on the amount that you can invest in nonretirement plan assets.
Summary
Are you self-employed and have a sizable capital-loss carryover? If so, you may want to forego part or all of the contribution to your retirement plan for a potential opportunity to realize capital gains in a future year that can be used to offset your capital-loss carryover. This can be a single- or multiyear strategy depending upon the amount of your capital losses.
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