Stacking capital loss harvesting with a SEP contribution

Tax professionals, let’s talk about a practical strategy that can help your clients save taxes: Engaging in capital loss harvesting and Simplified Employee Pension (SEP) IRA contributions in the same tax year.

In the ongoing effort to find tax minimization strategies that can be helpful for your clients, the combined approach of capital loss harvesting and a contribution to a SEP IRA can be a very effective method of reducing a client’s adjusted gross income (AGI) and tax liability. This article will further explore the compelling rationale for this combined method and provide a concrete application.

The strategic advantage: Maximizing tax benefits

Using capital loss harvesting in conjunction with contributions to a SEP IRA is a powerful strategy for a few important reasons:

• Dual impact on AGI: Both strategies can directly contribute to lowering AGI. While capital loss harvesting lowers gross income by offsetting capital gains and up to $3,000 in ordinary income, the AGI is reduced by the SEP contribution because it is an above-the-line deduction for self-employed individuals. The combination not only helps lower taxes owed today, but could also provide access to deductions and credits that phase out at higher income levels.
• Targeting different income streams: Capital loss harvesting primarily addresses investment income, mitigating the tax burden associated with capital gains. SEP contributions, conversely, directly reduce earned income from self-employment. By strategically employing both methods, tax liability is addressed across multiple income sources, maximizing the potential for overall tax savings.
• Potential for lower tax brackets and capital gains rates: A lower AGI generally means lower taxable income, which could align clients successfully in a more favorable ordinary income tax bracket. Overall, reduced taxable income could mean remaining long-term capital gains are taxed at a beneficial rate.
• Mitigating AGI-related limitations: Various deductions, credits, and taxes, such as the Net Investment Income Tax (NIIT), have AGI limits. By effectively lowering AGI through the combined use of capital loss harvesting and SEP contributions, clients may be able to avoid or minimize these limitations, preserving valuable tax benefits.
• Facilitating retirement savings with tax advantages: SEP IRAs have been commonly used as a retirement savings strategy for the self-employed and small business owners. Incentivizing and establishing SEP contributions will provide immediate tax relief and the payout history of a tax-deferred retirement vehicle.
• Strategic timing flexibility: Capital loss harvesting must be executed by the end of the tax year, while SEP contributions for a given tax year can be made until the tax filing deadline of the subsequent year (including extensions). This differential in timing allows for strategic year-end tax planning and the flexibility to determine the optimal SEP contribution amount after a clearer financial picture emerges.

Implementation protocol: A guide for tax professionals

To effectively implement the strategy of stacking capital loss harvesting with SEP contributions, consider the following steps:

Step 1: Conduct a comprehensive financial assessment

• Investment portfolio review: Review the client’s investment portfolio to assess probable capital losses.
• Capital gains analysis: Compute the amount of realized capital gains during the tax year.
• Self-employment income analysis: Calculate the client’s net self-employment income to calculate the maximum allowed SEP contribution.
• AGI projection: Calculate a projected AGI to determine what impact likely strategies will have.

Step 2: Determine strategic capital loss harvesting

• Identify loss opportunities: Find investments with a current market value below their cost basis.
• Establish optimal harvesting quantities: Seek to equalize capital gains and use up to $3,000 toward ordinary income reduction.
• Compliance with wash-sale rules: Strict adherence to the wash-sale rule (IRC §1091) must be maintained in order to retain losses as deductible.
• Consider strategic reinvestment: If market exposure is to be maintained, consider reinvesting in non-substantially identical assets.
• Meticulous documentation: Keep comprehensive records of every transaction to facilitate correct tax reporting.

Step 3: Consider effective SEP IRA contributions

• Confirm eligibility: Confirm the client’s self-employment or small business owner status.
• Determine contribution limits: Adhere to the IRS guidelines for SEP contribution limits for the relevant tax year.
• Facilitate SEP IRA establishment: Guide clients through the setup process if they do not already have a SEP IRA.
• Establish appropriate contribution level: Balance the tax savings to the client’s retirement savings goals and cash flow.
• Clarify deduction mechanism: Note above-the-line SEP contribution deductibility on Schedule 1 of Form 1040.

Step 4: Follow up with coordination and reporting

• Strategic timing: Implement capital loss harvesting at year-end and fund the SEP IRA at the due date of the tax return.
• Awareness of QBI interaction: Know how SEP contributions can influence the Qualified Business Income (QBI) deduction.
• Accurate tax reporting: Report capital gains and losses accurately on Form 8949, Sales and Dispositions of Other Capital Assets; Schedule D, Capital Gains and Losses; and SEP contributions on Schedule 1 of Form 1040.

Illustrative scenario

Assume self-employed consultant Sarah had $120,000 in net business income in 2024 and had an $8,000 long-term capital gain. On review, her investment portfolio contains $10,000 of unrealized losses.

Implementation:

• Sarah applies capital loss harvesting to realize the $10,000 loss, which she can apply to reduce the $8,000 gain and deduct $2,000 against her ordinary income.
• Sarah contributes $23,000 to a SEP IRA using her net business income.

Outcome:

• Her AGI is reduced by $2,000 under the capital loss deduction and $23,000 under the SEP contribution, for a total reduction of $25,000.
• Taxable income overall is greatly reduced.
• Her overall taxable income is significantly reduced.
• She earns high tax-deferred savings for retirement.

Be your client’s advisor

The strategic combination of capital loss harvesting and SEP IRA contributions presents a valuable opportunity for tax professionals to deliver significant tax savings and improve the financial well-being of their self-employed and small business owner clients with investment accounts. By obtaining thorough knowledge of the mechanics and benefits of the combined strategy, and by adhering to applicable tax regulations, we can effectively guide our clients toward optimal tax outcomes.