The old adage is, “You can’t spend pre-tax investment returns.” After-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 fluctuate during the year you likely will see opportunities to trim the IRS’s slice of your investment gains and income.
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.
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 so that it qualifies as a long-term capital gain with the maximum 20% tax rate.
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.
Know your tax bracket. The tax on your gains can fluctuate with your tax bracket. If your income or deductions 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.
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 taxpayers 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 does the 20% maximum rate kick in.
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 fewer 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 premium 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.
Make gifts of gains, but not losses. 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.
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 their parent’s top tax rate instead of the child’s.
You don’t want to give an asset that has declined in value. The recipient’s basis 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.
Give appreciated assets to charity. When you’re charitably inclined, consider 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 writing 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 capital 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 strategy 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.