The old adage is, “You can’t spend pre-tax returns.” Af- ter-tax returns are what count. 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 fluctu- ate 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 ordi- nary 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 for- ward 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 bot- tom 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 net- ting 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 dis- posed of. Here are key strategies that can be developed from these rules.
Take losses. 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 invest- ment 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 al- ready are tax advantaged. They recom- mend 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 inves- tors, 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 invest- ment 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 dif- ferent 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 tax- able account until you’ve held it more than one year. But investment fundamentals come before tax strategies.
When your investment strategy says it’s time to sell an investment, don’t hold it for months hoping it will mature to a long-term capital gain. It might make sense to wait if it will mature into a long-term gain in only a few weeks but waiting longer might not be worth the tax break. When you do take short-term gains, look for losses you can take to offset them. Know your tax bracket.
The tax on your gains can fluctuate with your tax bracket. If your income or de- ductions vary from year to year, you might factor that into your decision of when to sell. Someone who normally has a very high income might avoid the 3.8% net investment income surtax by selling long-term capital gain assets in a year when other sources of income are lower.
Details about the net investment income surtax are in the December 2020 issue of Retirement Watch. Other people might find that lower income one year reduces their long- term capital gains rate below 20%, to 15% or even 0%. In 2022, the long-term capital gains tax rate is 0% for single tax- payers with taxable income up to $41,675 and for married couples filing jointly with taxable income up to $83,350. The 15% long-term gains rate applies to single taxpayers with taxable income up to $459,750 and married couples filing jointly with taxable incomes up to $517,200. Only above those income levels will the 20% maximum rate begin.
The bottom line is that you might have an opportunity to take gains at a lower tax cost by selling in a year when you retire, lose a job, work few- er hours or business is down. When large tax deductions one year reduce your taxable income, that also could be a good time to take some extra capital gains. Also, consider other taxes in addition to the taxes on the gains when planning sales of profitable investments.
The gains will increase your adjusted gross income, and a higher adjusted gross income can trigger the Stealth Taxes, such as income taxes on Social Security benefits, the Medicare premi- um surtax, net investment income tax and more. Many people take large gains in one year only to find that the higher gains triggered one or more of the stealth taxes, increasing their effective taxes on the sales.
It might be better to spread the sales over several years. Consider the potential for triggering or increasing the Stealth Taxes before deciding to sell profitable investments. Make gifts of gains, but not loss- es. You can give investment assets to family members and let them sell the assets. This could reduce the family’s taxes when the person receiving the gift, usually a child or grandchild, is in a lower tax bracket. The tax rate on long-term capital gains might change from 20% to 15%, or even 0%. (The person receiving a gift has the same tax basis in the asset that you did, so he or she will have the same amount of capital gain as you would have.) You want to be sure that the person receiving the gift isn’t subject to the Kiddie Tax, which would make the gain taxable at the parent’s top tax rate instead of the child’s rate. See our Sep- tember 2018 and March 2020 issues for details about the Kiddie Tax. You don’t want to give an asset that has declined in value.
The recipient’s ba- sis will be the lower of your cost and the current fair market value. That means no one would deduct the loss in value that occurred while you owned the asset. It is better for you to sell the asset and deduct the loss on your return. Then, you can give the sale proceeds or something else.
Give appreciated assets to charity. When your charitably inclined, consid- er donating an appreciated investment instead of cash. You’ll be able to deduct the fair market value of the asset on the date of the gift. Plus, neither you nor the charity will owe any capital gains taxes on the appreciation that occurred while you owned the asset.
Giving an appreciated asset is likely to generate more benefits than writ- ing a check to charity. Hold for life.
When assets held in a taxable account are inherited, the heir increases the tax basis to the fair market value as of the date of the previous owner’s death. No cap- ital gains taxes are imposed on the appreciation that occurred during the previous owner’s lifetime. Since the federal estate tax doesn’t apply to most estates, a good strate- gy when you own investments with substantial gains is to continue holding them so the next generation can inherit and sell them without incurring any taxes.