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How can I invest so I don't pay a lot of taxes on capital gains, and get a break for my losses?
If you want to boost your investment returns but are wary since the dot-com crash, consider investing with an eye towards your taxes. Tax-smart investing can net you big increases in your gains, and help you make the most of your losses.
Here are ten ways you can maximize your gains, while minimizing your taxes.
1. Hold Stocks for the Long Term
When you sell stocks for a profit, you have to pay some taxes on the gain. How long you hold on to your stocks, though, makes a difference in the amount of taxes you pay on the sale.
- If you hold your stocks for 12 months or less, you pay your normal income tax rates on your gains, as high as 35 percent under the new tax laws.
- If you hold your stocks longer than 12 months, on the other hand, you pay only 15 percent on those gains. If you are below the 25 percent income tax bracket, your tax rate on such gains is only 5 percent!
2. Max-out Your Tax-favored Accounts
Take advantage of the long-term benefits of investing in tax-free or tax-deferred accounts like 401(k) plans and IRAs. Because you don’t pay taxes every year on the gains from these accounts, they compound at a higher rate, which puts you in a much better position at retirement.
In 2003, the maximum contribution limit for 401(k) and 403(b) plans was $12,000. This limit goes up to $13,000 for contributions made in 2004.
3. Sell Losers for a Tax Gain
When your stocks go down, you don’t have to hold onto them for fear of selling them and losing a lot of money. You can save quite a bit in taxes by selling at a loss.
Example:
You sell 100 shares of stock for $5 a share, and you bought the stock for $10 a share. Your capital loss is $500, which you can use to offset capital gains you earned from other sources. If you end up with more losses than gains, you can deduct up to $3,000 a year from your ordinary income (salaries, interest, etc.). If you still have losses left after the $3,000 deduction, you can carry them forward to the following year.
Advanced Tip:
When you erase gains with your losses, you need to erase similar gains first. For example, you must use long-term losses against long-term gains first, against short-term gains next, and against normal income last. Your best bet is to take long-term losses in years when you don’t have many long-term gains. Because long-term gains are taxed at up to 15 percent and short-term gains are taxed at up to 35 percent, leveraging your long-term losses against short-term gains saves money.
4. Avoid the Wash Sale Rule
One thing to watch out for when taking losses for tax purposes is the wash sale rule. Basically, this rule says that you can't buy a substantially similar security back within 30 days before or after you sell a security at a loss. If you do, the loss is not deductible on your tax return.
If you have a loss disallowed by the wash sale rules, you don't lose the loss forever; it simply gets added to the tax basis of the new stock purchase. Therefore, you will eventually receive a tax benefit from the disallowed loss when you finally sell the stock.
There are two ways to get around the wash sale rule.
First, you can be careful and only buy a security 31 days before or after you sell it at a loss.
Or, you can buy similar, but not substantially similar securities at the same time you sell at a loss. This can be particularly easy with mutual funds, because there are often many funds that invest in similar securities. There is no rule that says you can't sell one growth fund for a loss, then buy a similar growth fund from a different company with the proceeds.
5. Be Specific About Your Shares
When you purchase the same company’s stock at different times, each purchase is a separate lot for tax purposes. Each of these lots has a different tax basis (cost of the stock plus any commissions you paid the broker for the transaction), as well as a different purchase date.
While the IRS allows you to account for these lots in a number of ways, brokerages, especially Internet brokerages, tend to use the First In, First Out, or FIFO approach. While using FIFO might make your broker’s life easy, it can make your tax bill much higher than it needs to be.
Here’s why. With FIFO, your brokerage sells your oldest shares first, which usually means the lowest-priced shares. This can result in a higher tax bill because you tend to have the largest gains on these older shares. If you use the specific shares method, you can decide which shares to sell for every trade to keep your taxes to a minimum.
One caveat: Using the specific shares method takes a lot of record-keeping, which means that you will probably want to use a personal finance tool like Quicken to keep track of all your lots. In addition, you should talk to your brokerage about how to inform them about which shares to sell. Often, they require some written directions. Even if the Broker does not, to protect yourself from an overzealous IRS auditor, written directions are a good idea!
6. Don’t Buy Mutual Funds at the End of the Year
Unlike stocks, mutual funds must distribute all of their capital gains and dividends to their shareholders at least once a year. Usually, funds do this near the end of the year. If you buy into a fund right before the distribution date, you have to pay taxes on those distributions without enjoying any of the benefits of that year's gains.
If, on the other hand, you own a fund and you've been thinking about selling it, it might be a good idea to sell the fund before those distributions.
Either way, funds usually announce the distribution before making it, giving you time to decide.
7. Buy Tax-smart Funds
From a tax perspective, stocks are usually a better option than mutual funds because you don’t have to pay taxes on any capital gains until you sell.
Mutual funds, on the other hand, distribute gains every year. So you face capital gains taxes every year.
You can get the benefits of a fund (professional management and diversification) and keep capital gains taxes to a minimum by investing in tax-managed funds where managers take the necessary steps throughout the year to minimize capital gains distributions.
8. Buy Bonds
Generally, the interest you earn from municipal bonds is free of federal taxes, which means that a municipal bond with a 6 percent interest rate is really comparable to a taxable bond paying 8 percent.
People who live in high-tax states such as California and New York can get an extra boost by buying locally. In such states, an in-state municipal bond paying 6 percent is actually equivalent to a 9 percent taxable bond after you account for federal and state taxes.
9. Transfer Your Assets Now or Later
If you have children between the ages of 14 and 18, you can take advantage of their lower tax brackets by transferring your appreciated assets to them. You and your spouse can each give up to $11,000 a year in cash or assets to each of your children. Eventually, when the assets are sold, they are taxed at your child’s lower tax rate.
Be careful, though. After you transfer an asset to your children, it belongs to them. Also, colleges take into account your children’s assets when they consider financial aid applications, which mean that you could be jeopardizing your opportunities for financial aid. Make sure to consult a tax advisor before transferring assets.
If you are nearing an age where you’re thinking about your estate, holding on to long-held securities rather than selling them makes sense as an estate-planning tool. If, for example you bought Microsoft shares when it first went public, your shares would be worth a lot of money, but you would pay a huge amount in taxes if you sold them. If your heirs inherit those shares as part of your estate, the basis of the stock immediately increases to today's purchase price. All those gains disappear, meaning you can pass on a lot more.
10. Donate Appreciated Securities
When a stock grows in value, we say it has appreciated, and we certainly appreciate that. But if you sell an appreciated security, you face taxes on the capital gain. To avoid paying those taxes, you can donate the securities to a charity.
When you donate appreciated securities instead of cash, you take a charitable deduction for the market value of the securities, and you pass on the gains to the charity, which can sell the stock without paying any tax on the gains.
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