When it comes to investment taxes, understanding and managing capital gains is the key to minimizing the tax impact of your investments.
Here are some basics:
The tax impact of a specific investment depends both on
the payer's tax bracket - the rate used to calculate your ordinary income tax
the length of time the investment was held prior to sale
The tax is based on the difference between the original cost and the selling price. The difference reflects the increase in price - the stock's capital appreciation - or 'capital gain.'
Short-term capital gains are taxed at the tax payer's ordinary tax rate, and are defined as investments held for a year or less.
Long-term capital gains apply to assets held for more than one year. They are taxed at a lower rate than short-term gains to provide incentives for investors to make capital and entrepreneurial investments as well as to compensate for the effects of inflation and the corporate income tax.
The tax rate refers Adjusted Gross Income (AGI) which is the total income from all taxable sources minus allowable deductions. Income sources include business income (Schedule C) and/or salary, wages tips, commission, bonuses, unemployment benefits and sick pay as well as unearned income - dividends and interest. (Schedule B)
Allowable deductions include alimony or retirement plan contributions and other personal exemptions and deductions.
Capital gains taxes the difference between your 'basis' versus proceeds from the sale. This difference is your profit or loss.
The cost basis is an adjustment of the purchase price that factors in brokerage fees or taxes paid. Inherited stock is based on the stock price on the day the original owner died.
For example, suppose you are in the 30% tax bracket and make a $10,000 investment onJanuary 3, 2010. By November 1 - 10 months later-- you have a $2,000 gain on a $10,000 investment.
You'll pay about $600 in taxes if you were to sell onNovember 1, 2010, but only $300 if you sell beginning inJanuary 3, 2011or later. That's 3% of the original investment and 50% savings on the tax itself for waiting 60-days!
BUSH-ERA CAP GAIN BONANZA
The situation is even more interesting in the current environment: the long-term rate bottoms at 0 tax for the lowest 15% in ordinary taxable income through 2012.
The zero long-term cap gain rate has been available since 2008, thanks to the Bush-era tax cuts that began in 2003. This rate applies only to those in the 15% or lower tax bracket for ordinary income.
The zero rate applies if long-term capital gains plus regular taxable income for 2011 total less than $34,000 for an individual or $68,000 for married taxpayers, filing jointly. Long-term cap gain income over these limits is taxed at the higher rate.
The cap-gain tax is part of the on-going debate around tax reform. The rates had been due to increase at the end of 2010 but were extended by new legislation through the end of 2012. One reminder - certain states treat long-term capital gains as ordinary income regardless of federal tax code.
2 -- THE NETTING GAME
The first step to lower investment tax is to minimize cap gain rates by holding assets for more than one year
The second step is: minimize the tax paid in a given year by netting gains against losses.
Historically capital gains have held a preferential place in the tax code. We see this in lower trending rates. We also see it in IRS' method of computing the capital gains profit and loss on Form 1040, Schedule D
The Netting Game: First, the short-term gains and losses (those made in one year or less) are netted against each other for the tax year; then long-term gains and losses (those made in more than one year) are netted; and finally the remaining outcomes are combined together. Investors following instructions on Schedule D can implement this approach on their own. Tax advisors are also quite familiar with this practice.
EXAMPLE 1: a net short-term loss of $10,000 can be applied against a net long-term gain of $5,000 for a remaining short-term loss of $5,000 [-$10,000 + $5000 = -$5000]. In any given year, there is no limit on the amount of capital losses that can offset capital gains.
Remember -- as indicated on Schedule D-- after netting, a maximum of $3,000 of remaining losses may be deducted from ordinary income in any given year.
EXAMPLE 2: Purchase 400 Shares of S&P Unit Trust (SPY) @ 141.00 or $56.400
Within same tax year, sell 400 shares SPY at 131.00 for a $4000 short-term loss
Use $4000 loss to offset $4000 in other capital gains or $1000 in capital gains and $3000 in ordinary income
3- A STITCH IN TIME...
A third approach, the IRS also allows tax-payers a choice of accounting methods common in commercial world to further reduce cap gains -- the equivalent of LIFO (last-in/last-out) or FIFO (first-in/first-out)
Thus, you may choose the way you compute cost basis to lower your tax by selling the most expensive shares first.
Suppose you have purchased 1200 shares of XYZ stock over a two year period. You need to sell 800 shares of XYZ and want to minimize your tax consequence.
The selling price is a given. But what about the cost basis?
Since shares were bought at different time, the IRS permits the seller to calculate the lowest tax by designating the shares whose coast basis is the highest - which in turn would produce the lowest profit and therefore the lowest resultant capital gain tax.
In our example, you could sell the first 800 shares that you purchased two years ago, whose cost basis of $50 would result in a long-term gain of $20,000, with a tax bill of $3,000. On the other hand, if you choose to sell a specific tax lot instead, you can sell your most expensive shares first (even though they are short term) and still have a lower tax bill of $2,060.
Tax-loss harvesting is the action of selling your losing securities to deliberately create portfolio losses that offset your taxable gains. The result: a lower personal tax liability in a controlled and measured fashion - with an option to reestablish your position in the New Year at a lower cost basis and lower tax liability.
This is one reason the stock market often dips at yearend as investors actively dump their biggest losing positions to offset gains.
Sell and purchase shares of related but distinct stocks.
Effect is to realize loss and stay invested in same sector
EXAMPLE: sell 400 shares SPY at 131.00 for a $4000 short-term loss (as above) Simultaneously purchase 400 shares of IVV, iShares S&P 500 @ 130.00
Result: Realized loss in SPY shares but reestablish position in same sector with purchase of IVV
If IVV shares are sold in two years at 140, investor will pay 15% capital gains tax, or $600. (Assuming no capital gains tax rate increase). But tax loss already offset $3000 of ordinary income in the earlier year.
Assuming a 25% income bracket in the earlier year, the investor has realized a $750 saving tax year. After deducting the $3000 in the earlier year, the investor can carry $1000 forward to offset future gains, reducing cap gain by $150 (15% x $1000 loss carried forward).
The net tax paid will be reduced from $600 to $450. The whole exercise will result in a $300 savings (the $750 saved off of ordinary income in the earlier year, less the $450 cap gain tax paid in the later year).
Harvesting is an aggressive strategy that may be worth the effort when dealing with larger numbers. Watch out for the IRS Wash-Sale Rule designed to prevent investors from selling a stock in a losing position to offset a gain, only to turn around and buy the stock right back.
Under the 'Wash-Sale Rule', you may not sell a stock and buy it back within 30 days and claim a capital loss.