In the process of building wealth, saving a penny on your taxes is just as important as earning a penny in the markets.
Even losing money in your investments can help save on your taxes. The difference between what you paid for an investment and what it is currently worth is called a “capital gain” or a “capital loss.” As long as you continue to hold the investment, the gain or loss is “unrealized.” Selling the investment results in “realizing” the gain or loss. And this realized gain or loss must be reported on your taxes.
Because of the recent tax changes, realized capital gains are now taxed at a reduced 15% rate. Realized losses can offset realized gains, but you are also allowed to deduct up to $3,000 of capital losses against other types of income. If you have net losses in excess of $3,000 in one year, you can carry your losses forward to future years.
October is a good time to review your portfolio for investments that can be sold for a loss. You can use software to track your investments in order to make this review easier. Even a simple spreadsheet can compute the current value minus the cost basis of each investment. A positive number represents a gain and a negative number represents a loss. Any significant losses should be considered for tax-loss selling.
Ask yourself, “If you did not own that security now, would you buy it at current prices?” If the answer is no, sell. If the answer is yes, you would buy the same security at these lower prices, sell it anyway. Then wait 31 days and then buy it back again. That way you “realize” the loss for tax purposes, still hold the security, and have reduced your tax liability by sharing that loss with Uncle Sam.
Another technique is to double up. First purchase the same number of shares that you currently hold in that security. Wait 31 days. Then sell the original shares for a tax loss. Waiting a month between sale and buy back avoids a “wash sale” which would prevent you from taking the tax loss.
Most investments (stocks, bonds, mutual funds) are subject to the same tax rules, but owning individual stocks provide additional tax loss selling opportunities.
Compare two millionaire investors. The first buys a million dollars of a mutual fund that invests in two hundred different stocks. No stock represents more than $10,000 of the investment, and amount invested in each stock is $5,000. While the mutual fund might have a tame 10% return for the year, one of the underlying stocks in the fund might have doubled while two other lost 50% of their value during the year. This investor only owns shares in the mutual fund and cannot take advantage of any tax loss selling.
The second millionaire buys the same hundred stocks. Their overall portfolio still has a tame 10% return for the year, but they have additional choices that help them boost their earnings even higher. They can sell the two stocks that have a 50% negative return and take deduct the loss on their taxes. By selling the stocks with losses they realize their loss for tax purposes. By not selling their stocks with gains they avoid realizing those gains and therefore avoid paying any capital gains taxes.
The second millionaire won’t have to pay any capital gains on the stock that doubled in value until they sell it and realize the gain. Buying good stocks and holding them is one way of avoiding taxes by postponing the gain. There are ways of handling highly appreciated stocks that will also help reduce their tax impact.
The choice of stocks verses mutual funds depends on the size of an investor’s portfolio and their temperament. Mutual funds provide a means for you to diversify your portfolio even if the amount you are investing isn’t large. Even with a few hundred dollars investors can buy into a mutual fund that diversifies your investment over hundreds of stocks. Only as your portfolio size approaches a half of a million dollars can it be similarly diversified using individual stocks. Finally, an investor has to be willing to stomach having a significant number of stocks with losses to benefit from individual stock investments.
Therefore, during October, review your portfolio for investment losses to sell, and consider some individual stock purchases if your portfolio approaches a half a million dollars.
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