The old adage is, “You can’t spend pre-tax returns.” After-tax returns are what count.
Well, the tax rules on investments are in effect all year, but few people take advantage of that.
Too many people don’t start thinking about investment taxes until near the end of the year, or even after the year is over.
But actions you take, or don’t take during the year, affect the after-tax return on your investments.
Don’t leave your investment money on the table for the IRS to rake in.
Engage in investment tax planning year-round.
Keep these tax rules and strategies in mind all year, and as markets fluctuate during the year you likely will see opportunities to trim the IRS’s slice of your investment gains and income.
First, here’s a refresher on some basic facts.
When you sell a capital asset, such as an investment, from a taxable account, you’ll have a gain or loss, and it will be either short-term or long-term.
When you held the asset for one year or less, the gain or loss is short-term.
Hold the asset for more than one year, and the gain or loss is long-term.
A long-term gain faces a maximum tax rate of 20% (23.8% if your income is high enough to trigger the 3.8% net investment income surtax).
But the capital gains tax rate depends on the amount of your taxable income.
For many people, the long-term capital gains tax rate is lower, 15% or even 0%.
Short-term gains are taxed as ordinary income at your regular tax rate.
Capital losses first are deducted against any gains. When losses exceed gains, up to $3,000 of net losses can be deducted against other income.
Any additional net losses are carried forward to future years to be used in the same way until they are exhausted.
You report capital gains and losses on Schedule D of Form 1040.
What many people don’t realize is that first you separately net the short-term and long-term transactions.
On the top half of Schedule D, the short-term transactions are netted against each other to compute either a net short- term capital gain or loss.
On the bottom half of Schedule D, the long-term transactions are netted to arrive at a long-term net gain or loss.
For example, suppose after the netting process you have a net short-term capital loss of $5,000 and a net long-term gain of $7,000.
The result is a net long-term capital gain of $2,000 taxed at your long-term capital gains rate.
You don’t recognize a gain or loss on an investment until it is sold or disposed of.
Here are some key strategies that can be developed from these rules.
Most investors are averse to taking a loss.
They often plan to hold the investment at least until it returns to their purchase price.
But, unless you have good reasons to expect a turnaround, selling an underwater investment and taking a tax loss often is the better use of your capital.
The loss reduces taxes on either your capital gains for the year or, when losses exceed gains, up to $3,000 of other income.
A big loss can be carried forward to future years and reduce taxes on future gains and some other income, sometimes for years.
The bonus is that after selling an investment at a loss, you can invest the sale proceeds in a more productive investment.
Over the long-term, you’re likely to generate more wealth by taking a loss to reduce taxes today and free the capital to invest elsewhere instead of waiting for the losing investment to rebound.
Some tax advisors recommend against selling a losing investment in a year when you have a large amount of capital gains, because those gains already are tax advantaged.
They recommend waiting until the next year to sell, so the losses are more likely to offset short-term gains or ordinary income.
But you don’t know if you’ll be able to use the losses that way next year.
Plus, the capital remains tied up in the losing investment longer and could lose even more value.
For most investors, it’s better to take the loss and let it reduce the taxes on some or all of your gains for the year to zero.
If you still like the investment, you can sell it, deduct the loss and reinvest the proceeds in the same asset after waiting more than 30 days.
Or you can invest right away in another investment that isn’t “substantially similar.”
This means you can sell a mutual fund and invest in a different mutual fund with a similar investment style at a different fund company.
Or you can sell a stock and buy either another stock in the same industry or an ETF focused on that industry.
Let gains run.
Short-term capital gains are taxed as ordinary income at your highest tax rate.
Ideally, you want to avoid selling an investment in a taxable account until you’ve held it more than one year. But investment fundamentals come before tax strategies.
We’ll pick this up again in next week’s edition of Retirement Watch Weekly, in which I’ll share four more ways to increase after-tax investment returns.