Fellow Washingtonians: You may have noticed, on April 25, our legislature passed a new statewide capital gains tax, which the Governor signed into law on May 4, 2021.
You may wonder…. How does this impact me? Is there anything I should be proactively doing? Is this even for real?
Today, we are going to discuss financial planning for the new Washington State Capital Gains Tax
First, an overview of the tax:
Senate Bill 5096 levies a 7% tax on Washington residents’ annual long-term capital gains exceeding $250,000. For example, if your annual gains are $249,999, no additional tax is incurred; if they’re $250,050 you incur a 7% state tax on that extra $50.)
Barring any legal challenges, the new tax kicks in beginning January 1, 2022. It is not expected to apply to past gains; and its proceeds are currently earmarked for K-12 education, early learning, and childcare.
So, what’s a Washington taxpayer to do?
Let’s cover 7 key tips and topics on how to fit the new tax into your financial future
1. Plan, But Don’t Panic, Things Can Change
First and foremost, don’t panic. Or at least don’t let the news trick you into becoming reactive rather than proactive about your financial planning. Even as we post this piece, SB 5096 is being challenged in court. This means details could change by the time the law goes into effect … if it even does.
So, don’t rush to react. But don’t ignore it, either. Life is filled with uncertainty, and always will be. We suggest taking time today to think through how you might best manage the new tax, based on your unique financial circumstances. The more “what if ?” scenarios you consider with your financial advisor and/or tax planner, the better prepared you’ll be to respond judiciously, no matter what happens next.
What does that plan look like? Keep reading.
2. Review Your Short- and Long-Term Investment Strategies
Remember, taxes are a passenger on your financial plane; they aren’t the pilot. So, yes, you always want to be mindful of taxes and any income thresholds that may trigger them. But don’t be afraid to realize taxable gains whenever your greater financial good warrants it.
For example, disciplined portfolio rebalancing is essential for maintaining your expected market returns and risk exposures. As such, incurring capital gains to rebalance when appropriate delivers far more value to your investment success than the impact SB 5096 may have on the results. Also, down markets may give you the chance to offset those gains through tax-loss harvesting, which is something that is often overlooked.
Moreover, when it comes to tax planning, we look at your LIFETIME tax strategy, where it’s fine to lose a few annual tax-return battles to win the war.
In other words, you don’t necessarily want to minimize taxable gains every year. Instead, you want to think strategically about when it makes the most sense to take your gains—given your tax bracket, income streams, charitable intent, retirement strategies, estate plans, and similar lifetime goals.
3. Revisit Your Legacy, Charitable, and Gifting Strategies
Again, we are not suggesting you alter your legacy, charitable, or gifting intentions to save a few tax bucks. But while you’re preparing your philanthropic and estate plans, your dollars may stretch further with some intentional tax planning. The techniques involved are beyond the scope of this article, but once your plans are in place, there are all sorts of gifting and giving opportunities available, such as 529 college education plans, Donor Advised Funds, and various charitable trusts. With a caveat: SB 5096 currently has some unique provisions regarding charitable donations and thresholds. Also, beneficiaries may be affected in various ways by the new tax themselves. So, consult with a tax professional before rushing into anything.
4. Consider Where You Really Live
The new tax applies to Washington residents. But who is a “resident”? If you live, work, vacation, or snowbird in multiple states (physically or virtually), pay close attention to the law’s residency requirements, so you’re aware of your options. For example, where you are when you generate your capital gains and losses may impact your tax bill—for better or worse. That said, other states’ tax treatments may be even higher than ours, so you may want to compare and contrast your options before generating big-ticket taxable gains. Either way, be sure to track the number of days you spend in Washington, with paperwork demonstrating where your primary tax domicile is based.
5. Tips for Business Owners
Do you own or co-own a business? At some point, in some form or fashion, you or your heirs will be selling or otherwise transferring that interest. Even without SB 5096, careful planning is warranted, long before the transfer occurs. When possible, you may wish to sell your business over time, during favorable markets, and/or by deploying deferred compensation options. As SB 5096 is currently written, it also carves out special definitions for family businesses. For example, one qualification is that your worldwide gross revenue (not your profit) must be under $10 million in the 12 months prior to sale. Bottom line, if you haven’t started your business succession plans, now is as great a time as any; don’t leave something this important to the last minute.
6. Washington State vs. Federal Tax Codes
As if all this weren’t fun enough, the way you or your tax professional may calculate your state vs. federal capital gains may differ. For example, there is currently no additional marital deduction on the Washington state calculations. That $250,000 threshold before the 7% tax kicks in is the same whether you’re filing individually or jointly. Business interests and carryforward losses outside of the state also may be calculated differently for state versus federal returns.
7. Some Good News! What Does NOT Count as a WA State Taxable Gain
We’ll conclude with a number of realized capital gains that do not currently count toward that $250,000 annual threshold. Basically, it appears the intent is to mostly include gains realized from investments—such as stocks, bonds, mutual funds, and ETFs—held in standard brokerage and advisory accounts.
|Here are examples of gains that are excluded:|
|Short-term capital gains (for securities held less than a year)|
|Distributions from IRAs, 401(k)s and most similar retirement plan accounts|
|Gains from the sale of your primary residence, as well as most residential real estate gains|
|Various other miscellaneous gains incurred in specialized industries (such as farming, fishing, and timber) … but read the fine print if they might apply to you|
Summary: Tax Planning and Beyond
Summing it up, it might help to remember the bright side of gains. When you realize a capital gain in your investment portfolio (which is mostly what this new tax is targeting), it means you’ve made money by investing in the market. So, even after you’ve paid taxes on those gains, you’re still left wealthier than if you never had any “profits” to report.
On the other side, we understand that might not leave you feeling any better about parting with any more of your hard-earned money and paying a new tax. That’s why one of the key goals in financial planning is to minimize the damage done by taxes and other costs (AKA not overpaying our taxes) by:
- Talking regularly with your team, including your financial advisor, CPA, and estate planning attorney
- Creating a lifetime tax, investment, gifting, and estate plan
- Proactively monitoring new developments that may impact your financial plans and wealth strategy
- Thoughtfully considering when changes may be warranted, and implementing them when they are
Would you like to continue this retirement conversation with us directly?
Does your investment strategy include the sort of integrated financial and tax planning we just described? Are you proactively and properly updated on how new developments may impact you?
We would be glad to talk with you and are happy to share the names of other professionals we closely collaborate with, such as accountants and estate planners.
To help potential clients make an educated and informed decision about our firm, we’ve designed a no-cost, no-obligation five-step process we call “Sleep On It.”